May 24th, 2023: Investing in a Narrow Market: Opportunities and RisksIn their recent report, J.P. Morgan strategists have underscored that the stock market this year has exhibited the narrowest breadth it has seen since the 1990s. James Regan, the head of research at D.A. Davidson, also observed that market gains are becoming increasingly concentrated in a smaller number of stocks, a trend that may not be sustainable in the long run. This development is clearly demonstrated in the performance gap between large and small cap stocks, with large cap stocks outperforming small cap stocks by nearly 6%. Moreover, this concentration is even more pronounced within large cap stocks, as the NASDAQ has outperformed the Dow by an astonishing 17%. Drilling down further, large cap growth stocks are currently outperforming small cap growth stocks by a significant 10%.
I believe that the reason for this concentration is that in uncertain economic times, investors tend to prefer large, stable companies with proven track records of success. These companies are perceived to be more resilient during a recession than smaller, riskier stocks. Concurrently, there has been a trend of investors engaging in more speculative trading, hoping to capitalize on the gains of a few high-performing stocks, rather than diversifying their portfolios. Artificial intelligence (AI) is a contributing factor to the increasing narrowness of the stock market. The dominance of technology stocks, particularly those in the large-cap growth category, is benefiting from investor enthusiasm and excitement surrounding AI. The meteoric rise of OpenAI’s ChatGPT further fuels this trend, providing a boost to the tech giants that are rallying around the announcements and potential of AI.
In the current economic climate, large-cap stocks have been thriving due to their cash cow status, pricing power, and the ability to implement cost-cutting strategies. Several large-cap giants, including PepsiCo, Nestle, and Unilever, have raised prices without negatively affecting demand, even amidst recent inflationary pressures. For instance, in the first quarter of this year, these companies reported robust earnings results partly due to their ability to raise prices while offsetting rising costs. Ed Yardeni of Yardeni Research posits that this indicates consumers’ willingness to pay more for these products despite the broader inflationary environment. While pricing power is crucial for a company’s financial health, many large-cap tech companies such as Apple, Microsoft, Amazon, Google, and Meta have experienced plateauing revenues. Nevertheless, they have managed to increase profits by implementing cost-cutting measures and buying back stock, transforming themselves into cash cows that generate consistent cash flow and provide attractive returns to investors. In contrast, small-cap stocks lack these benefits.
Investors are rewarding well-managed businesses with competitive advantages. Over time, these businesses can reinvest their earnings into research and development, marketing, or other strategic initiatives that can further enhance their competitive advantages and drive future growth. These businesses are more likely to maintain their profitability and continue growing, even when the broader economy is struggling, which can help preserve investor capital and generate more reliable returns over the long run.
The major risk associated with this concentrated market is that many companies are facing slowing revenue growth, yet their stocks continue to rise. This is causing the price-to-earnings (P/E) ratios to increase for large cap growth stocks. As share prices continue to climb, while earnings growth lags, P/E ratios have been pushed higher, reflecting a potential disconnect between valuations and the underlying fundamentals of these companies. I remember the days when Apple, Microsoft, and other large technology stocks were trading at 15 P/E ratios, and today those same ratios are in the range of 20-50. Investors may be paying a premium for the shares of these businesses, even though their earnings growth may not be as robust as it once was, which can lead to concerns about overvaluation and market sustainability. Consequently, markets will remain volatile as there can always be a sudden shift in investor sentiment. Richer valuations, as indicated by elevated P/E ratios, may leave these stocks more vulnerable to price declines if future earnings fail to meet investor expectations.
At some point, I anticipate that speculative investors will need to exercise more caution, and there will be an investment opportunity to buy the overlooked mid and small cap stocks. I continue to believe this is one of the best investment environments for both conservative and more aggressive investors. There are investment opportunities everywhere, except for holding cash that earns zero interest. Looking ahead, the next market hurdle will be the debt-ceiling drama this summer. As always, it’s the politicians who will delay the resolution until the eleventh hour. I’ll write more about this topic and the potential market impact in next week’s update.
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In their recent report, J.P. Morgan strategists have underscored that the stock market this year has exhibited the narrowest breadth it has seen since the 1990s. James Regan, the head of research at D.A. Davidson, also observed that market gains are becoming increasingly concentrated in a smaller number of stocks, a trend that may not be sustainable in the long run. This development is clearly demonstrated in the performance gap between large and small cap stocks, with large cap stocks outperforming small cap stocks by nearly 6%. Moreover, this concentration is even more pronounced within large cap stocks, as the NASDAQ has outperformed the Dow by an astonishing 17%. Drilling down further, large cap growth stocks are currently outperforming small cap growth stocks by a significant 10%.
I believe that the reason for this concentration is that in uncertain economic times, investors tend to prefer large, stable companies with proven track records of success. These companies are perceived to be more resilient during a recession than smaller, riskier stocks. Concurrently, there has been a trend of investors engaging in more speculative trading, hoping to capitalize on the gains of a few high-performing stocks, rather than diversifying their portfolios. Artificial intelligence (AI) is a contributing factor to the increasing narrowness of the stock market. The dominance of technology stocks, particularly those in the large-cap growth category, is benefiting from investor enthusiasm and excitement surrounding AI. The meteoric rise of OpenAI’s ChatGPT further fuels this trend, providing a boost to the tech giants that are rallying around the announcements and potential of AI.
In the current economic climate, large-cap stocks have been thriving due to their cash cow status, pricing power, and the ability to implement cost-cutting strategies. Several large-cap giants, including PepsiCo, Nestle, and Unilever, have raised prices without negatively affecting demand, even amidst recent inflationary pressures. For instance, in the first quarter of this year, these companies reported robust earnings results partly due to their ability to raise prices while offsetting rising costs. Ed Yardeni of Yardeni Research posits that this indicates consumers’ willingness to pay more for these products despite the broader inflationary environment. While pricing power is crucial for a company’s financial health, many large-cap tech companies such as Apple, Microsoft, Amazon, Google, and Meta have experienced plateauing revenues. Nevertheless, they have managed to increase profits by implementing cost-cutting measures and buying back stock, transforming themselves into cash cows that generate consistent cash flow and provide attractive returns to investors. In contrast, small-cap stocks lack these benefits.
Investors are rewarding well-managed businesses with competitive advantages. Over time, these businesses can reinvest their earnings into research and development, marketing, or other strategic initiatives that can further enhance their competitive advantages and drive future growth. These businesses are more likely to maintain their profitability and continue growing, even when the broader economy is struggling, which can help preserve investor capital and generate more reliable returns over the long run.
The major risk associated with this concentrated market is that many companies are facing slowing revenue growth, yet their stocks continue to rise. This is causing the price-to-earnings (P/E) ratios to increase for large cap growth stocks. As share prices continue to climb, while earnings growth lags, P/E ratios have been pushed higher, reflecting a potential disconnect between valuations and the underlying fundamentals of these companies. I remember the days when Apple, Microsoft, and other large technology stocks were trading at 15 P/E ratios, and today those same ratios are in the range of 20-50. Investors may be paying a premium for the shares of these businesses, even though their earnings growth may not be as robust as it once was, which can lead to concerns about overvaluation and market sustainability. Consequently, markets will remain volatile as there can always be a sudden shift in investor sentiment. Richer valuations, as indicated by elevated P/E ratios, may leave these stocks more vulnerable to price declines if future earnings fail to meet investor expectations.
At some point, I anticipate that speculative investors will need to exercise more caution, and there will be an investment opportunity to buy the overlooked mid and small cap stocks. I continue to believe this is one of the best investment environments for both conservative and more aggressive investors. There are investment opportunities everywhere, except for holding cash that earns zero interest. Looking ahead, the next market hurdle will be the debt-ceiling drama this summer. As always, it’s the politicians who will delay the resolution until the eleventh hour. I’ll write more about this topic and the potential market impact in next week’s update.