How Not To Time The Market

I’ve been on about so-called “concentration risk” in US equities. Everyone has.

The discussion isn’t particularly complicated, but in its current manifestation, it admits of more nuance over time.

US equity benchmarks are dominated by a few heavily-weighted tech titans, on whose shoulders the burden of the rally disproportionately rests. In addition to being the best companies in the world on a variety of key metrics, the FAAMG cohort has benefited immensely from the “slow-flation” macro regime, defined by lukewarm growth and subdued inflation across advanced economies.

The generic worry is just that a benchmark dependent on too few names is a benchmark that’s inherently vulnerable. And the S&P 500 has indeed become synonymous with a relative handful of companies.

The figures (above) raise a number of existential questions, not least of which is whether it even makes sense to talk about an “S&P 500.” Increasingly, “corporate America” is just a reference to, at most, 10 companies.

But as eye-popping as visuals like those are, the reality of capitalism is that some companies thrive and eventually become pseudo-monopolies. Contrary to popular belief, monopolies are essential. As Immanuel Wallerstein reminds us, in a totally free market, “it would always be possible for the buyers to bargain down the sellers to an absolutely minuscule level of profit and this low level of profit would make the capitalist game entirely uninteresting to producers, removing the basic social underpinning of such a system.”

In other words: The system needs quasi-monopolies to function. Ironically given the current bipartisan push to regulate America’s largest tech companies, only a strong state can support quasi-monopolies. Think: patents, subsidies, tax incentives and protectionist measures. Governments aren’t actually “anti-monopoly.”

So, what’s often described (and decried) as an aberration is in many respects just the natural way of things in the system we’ve created. Perhaps today’s tech monopolies need to be reined in. Personally, I’m torn on the issue. I think Facebook is socially destructive, but I enjoy virtually everything about Google and its services.

If I’m being honest, I have no problem whatsoever with Google knowing everything about me, because as far as I can tell, it leverages that knowledge in the service of helping me get things done more often than it leverages it to exploit me. I realize that’s naive, but I really don’t care. Because when I want to find the nearest home improvement store (or remember a password I haven’t used in three years), Google’s got my back. In that moment, whatever else the AI might be doing with my information is irrelevant. Last week, for example, I needed some double-sided adhesive tape capable of anchoring at least 10 pounds, because a piece of sculpture I bought is top-heavy and prone to tipping over. Maybe someday, I’ll regret that Google knew everywhere I drove on a random Wednesday. But right then, I just needed to find a Home Depot. And I did. Thanks to Google.

Tens of millions of people have experiences like that every, single day. And that’s why “this time may be different,” to employ the most maligned phrase in all of finance. “The largest S&P 500 companies currently have a proven track record of delivering organic growth, higher pricing power and superior capital return,” JPMorgan’s Dubravko Lakos-Bujas wrote, in a Monday note, adding that the companies “have several advantages over prior leaders given most are platform companies with captive users, global reach, enviable tech stack, stronger balance sheets and low asset intensity.”

I should note that Lakos-Bujas’s point wasn’t necessarily to tout the virtues of the FAAMG cohort. JPMorgan has long argued that bond proxies, low vol shares and other perennial winners from the “slow-flation” macro regime have enjoyed bubble-like relative performance versus various manifestations of cyclical value. Indeed, Lakos-Bujas on Monday wrote that “investors have shed High Beta stocks precipitously and are back to paying record premium for Low Vol stocks.”

Happily, that rotation (into the safety of mega-caps and bond proxies) has kept the S&P elevated around JPMorgan’s bullish price target, but the bank views the associated “sharp de-risking and outright bear market in High Beta stocks on both sides of the barbell (Value and Growth)” as an opportunity. But that’s for another article.

Getting quickly back to the matter at hand, concentration at the benchmark level is nothing new. The figure (below) is a snapshot covering the last four decades.

Note the annotations. There have been eight notable periods of rising market concentration among the top 10 stocks. Certainly, the current episode is dramatic, but as Lakos-Bujas pointed out, the weight of stocks 11-20 is actually below the average over the last 40 years.

More to the point, attempting to time the market based on rising concentration in the top 10 names is a fool’s errand. Of course, JPMorgan didn’t put it that way (they were more diplomatic), but the bottom line is that concentration just isn’t a reliable indicator.

As the table (below) shows, in just two of the episodes circled in red (figure above) was the S&P lower six months hence, and only by 4% in each instance. During the other five episodes, stocks were higher six months later.

Looking 12 months out tells the same story. Only during the dot-com fiasco were returns negative 12 months after a notable rise in top 10 market concentration.

As for whether the largest stocks are wildly overvalued, JPMorgan seems to doubt it. “Given the largest stocks are considered ‘pseudo-bonds’ with low earnings volatility, ample liquidity and high carry / shareholder yield, the valuation premium of 4x on forward PE is not unreasonable,” Lakos-Bujas suggested.

Again, JPMorgan’s tactical investment thesis for US equities in the near- to medium-term doesn’t necessarily revolve around an uber-bullish take on the top 10 stocks. Rather, the point was simply to say that if market timing is your thing, concentration risk may not be the best indicator.