We regularly talk of a “perpetual motion machine” in markets that drives benchmarks ever higher and serves to perpetuate the dominance of a relative handful of behemoths.
It’s something of a tired reference by now, but not because it’s any less true than it was when Howard Marks discussed it in a widely-cited 2017 memo. Rather, the longer a given dynamic persists, the more tempting it is to summarily dismiss the naysayers.
Nobody would totally “dismiss” Marks, but one (major) hiccup in late 2018 notwithstanding, the perpetual motion machine is still in operation. We’ll quote the 2017 memo again because, at least for some of us, it never gets old:
Importantly, organizers wanting their “smart” products to reach commercial scale are likely to rely heavily on the largest-capitalization, most-liquid stocks. For example, having Apple in your ETF allows it to get really big. Thus Apple is included today in ETFs emphasizing tech, growth, value, momentum, large-caps, high quality, low volatility, dividends, and leverage.
The large positions occupied by the top recent performers — with their swollen market caps — mean that as ETFs attract capital, they have to buy large amounts of these stocks, further fueling their rise. Thus, in the current up-cycle, over-weighted, liquid, large-cap stocks have benefitted from forced buying on the part of passive vehicles, which don’t have the option to refrain from buying a stock just because its overpriced.
Like the tech stocks in 2000, this seeming perpetual motion machine is unlikely to work forever. If funds ever flow out of equities and thus ETFs, what has been disproportionately bought will have to be disproportionately sold. It’s not clear where index funds and ETFs will find buyers for their over-weighted, highly appreciated holdings if they have to sell in a crunch. In this way, appreciation that was driven by passive buying is likely to eventually turn out to be rotational, not perpetual.
Leaving aside the (vociferous) debate about the extent to which Marks’s overarching critique is correct, we wanted to use it as a framework (or, at the least, an “excuse”) to make a couple of quick observations.
First, as noted Monday evening, the Nasdaq 100 is on the verge of hitting a relative record high versus the Nasdaq Comp. “A stock market record is in sight, but most investors probably aren’t even aware of it”, Bloomberg’s Andrew Cinko writes, adding that “the last time this happened was the late 1990s, when the relative relationship went parabolic”.
Cinko goes on to say that looking at the relative performance between the S&P 100 and the Russell 3000 paints a less dramatic (and thereby less worrisome) picture (see the bottom pane).
“Mega-caps are having a good run over the last year, but otherwise the S&P 100 has been making no ground against the broader market”, he notes, on the way to remarking that when you “mix in a broad array of companies [it] not only dilutes tech’s contribution but also waters down fears that the biggest of the big are getting too outsized versus the rest of the market”.
A quick look at the Nasdaq 100 versus its equal-weighted counterpart underscores the prevailing trend in tech land.
Meanwhile, SocGen’s Andrew Lapthorne set out this week to analyze the impact of mega-cap stocks on S&P 500 performance. His conclusions are notable, if not wholly surprising.
“Historically, being one of the biggest stocks in the S&P 500 was not an advantage, with the ten biggest stocks lagging the market by 150bp per annum on average since 1990 while the top five stocks lost 100bp per annum vs the benchmark”, Lapthorne says, before observing that this situation “has changed dramatically during the past decade [and] more specifically the past three years, with the top five outperforming by a remarkable 500bp per annum and the top ten by 260bp”.
As the occupant of the Oval Office would put it: “Bigly”. Or, in the more refined formulation of the catchphrase: “Big league”.
None of this is “new” (or “news”) per se, but it’s worth keeping yourself apprised. We’ll leave you with one final visual, this one courtesy of Bloomberg’s Luke Kawa. The yellow line is software & services plus media & entertainment stocks. The white line is the S&P.