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Weak When Narrow

A common phrase often expressed by the financial media is that “markets hate uncertainty.” Of course, markets are always uncertain because human beings cannot see the future. That is a key reason why we attempt to frame investment decisions in terms of what we can observe; the risk compensation or valuation to give a sense of the “odds.” Of course, even valuation is conditional on cash flows, earnings, balance sheets and the discount rate.

A now widely observed feature of the price action so far this year is the concentration of global equity performance in a handful of companies. That is evident in the divergence between the market cap weighted performance of the S&P500 (+14%) compared to the equal weighted S&P500 performance (+2.8%) year to date. Long mega-cap US tech has been the key “winning” position in 2023 with a few exceptions such as Japanese equities (+13.1% in USD). The performance of US mega-cap tech has reinforced the prevailing bias or preference for this sector relative to other markets. However, from our perch there are a few key risks related to this trade that should alarm investors.

First, although valuation is not a useful timing signal, the MSCI US information technology sector is trading just under 7 times sales. The twin peaks in 2000 and 2021 was 8 times sales. Second, there is a divergence between the (real) discount rate and the performance of mega-cap technology stocks. Third, as the great Bob Farrell observed “markets are strongest when they are broad and weakest when they are narrow”. The current relative performance is the narrowest since the lead-in to the first technology bubble in 2000. Coincidently, the last time the equal weighted S&P traded this far below the 200-day moving average was in 2020, 2018, 2007 and 2000. None of those episodes are bullish parallels (chart 1).

Another interesting observation we have studied in the past is the relationship between corporate profits as measured by the national accounts and S&P500 earnings. While this is not comparing apples with apples, it has often provided an interesting divergence at major cyclical turning points (chart 2 – note the 2000 and 2007 episodes). The national accounts include all companies, not just the major listed companies which likely explains part of the divergence. On the other hand, the difference might be a fundamental signal of underlying macro weakness. Moreover, it is more challenging for companies to “fudge” tax returns to the IRS. Put another way, it is like comparing GAAP and Non-GAAP earnings.

As Soros said noted on speculative episodes, “financial markets, far from accurately reflecting all the available knowledge, always provide a distorted view of reality. The degree of distortion may vary from time to time. Sometimes it’s quite insignificant, at other times, it is quite pronounced. When there is a significant divergence between market prices and the underlying reality, there is a lack of equilibrium conditions.”

“Every bubble has two components: an underlying trend that prevails and a misconception relating to that trend. When a positive feedback loop develops between the trend and the misconception, it sets a boom-bust process in motion. The process is liable to be tested by negative feedback along the way. If it is strong enough to survive these tests, it reinforces both the trend and the misconception.”

From a tactical perspective our sense is that the renewed rise in US Treasury yields over the past few months and the consensus belief in “higher-for-longer” rates is likely to be tested by the deterioration in the leading indicators of the US labour market (the Fed’s reaction function) and the renewed tightening in US dollar liquidity and financial conditions. The higher discount rate is also probably a challenge for assets with long duration cash flows or those based on the hope of future growth such as mega-cap tech in the United States. The good news in Asia is that consensus beliefs on future growth are already considerably more pessimistic. Another phase of weakness in Asia is an opportunity to accumulate equity in this region.


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