Q2 2024: PFM Quarterly Commentary
At Peak, we possess a deep appreciation of history. It tells us that each market cycle features new leading companies, changing social backdrops, and evolving structural narratives that fuel growth and innovation. Also consistent over the years are the human behaviors that, collectively, have driven markets in never-ending cycles of boom and bust. Fear, greed, and the inability to imagine that tomorrow might be different from today create these textbook market cycles that have repeated themselves for the last 150 years.
Constantly revisiting the past informs our thoughts about the future. Today, the rise of artificial intelligence amid technology’s wider dominance in the marketplace has rightly captured investors’ attention. In fact, a new milestone was reached in June 2024 when AI chipmaker Nvidia (symbol: NVDA) became the largest company in the S&P 500, leapfrogging both Apple and Microsoft. This achievement is remarkable considering Nvidia’s only recent rise from relative obscurity. Having a little-known company become the most important entity in the entire domestic stock market is a notable departure from the eleven previous firms to have held the title: General Electric, General Motors, AT&T, Philip Morris, Wal-Mart, Exxon Mobil, DuPont, IBM, Cisco Systems, Apple, and Microsoft. This list illustrates how dramatically the markets’ compositions shifted over the last century, as the country transitioned first from an industrial powerhouse to a consumer-driven economy, and then most recently, to one that’s tech-centric.
Our assumption is that investors in the 1960s could not have envisioned a time where behemoths General Motors and AT&T weren’t jockeying to be the largest company in the S&P 500. Now, these former leaders are the 64th and 160th biggest companies in the index, with their current size combined equaling just 6% of Nvidia’s market capitalization. Transformations of this magnitude are nearly impossible for people to predict because it represents a complete departure from their current sense of understanding. In fact, voicing such a seemingly outlandish vision would have surely been met with ridicule.
Humanity’s aversion to change was researched by Dr. Daniel Kahneman, who won the Nobel Prize in 2002 for his work in behavioral economics, whereby he identified biases and mental shortcuts we employ when making decisions based on our thinking of the future. In many cases, but especially concerning the investment markets, Dr. Kahneman concluded that participants anchor their expectations about the future based on how things are today. Kahneman observed that people have both a fear of regret associated with being wrong and an innate resistance to going against the norm. These fears of being incorrect and/or ridiculed seemingly outweigh the benefits of being accurate when assuming an unpopular position.
One can observe this behavior simply by sampling the investment-related media. One analyst after another will suggest investors purchase shares of NVDA, with ever rising target prices. The slightest hint of dissent from their peers is noticeably absent. Clearly, those analysts have been correct until now and may continue to be for longer still, but in our opinion, this is cause for consternation. Every market cycle has featured stocks that are seemingly invincible, and like AT&T, General Motors, Philip Morris, and countless other “can’t miss” stocks over the last century, history suggests the inevitable will occur. Times will change, great success will attract fierce competition, the social/political landscape will evolve, and as a result, investors’ appetites will adjust accordingly.
To be clear, we love Nvidia; it’s a great American success story that may reshape life as we know it, presumably for the better. In fact, we have ample exposure to it in our clients’ portfolios. What we are instead trying to draw attention to is how the domestic stock market’s recent appreciation is driven by a small subset of stocks. Historically, participation in bull markets narrows with age as leading companies attract more investor capital than their peers. Worth highlighting is that the limited breadth of participation in the S&P 500 in 2024 is rivaled only by the late stages of the tech mania during the late 1990s.[i]
The S&P 500 index is weighted by size (i.e., capitalization) of the individual companies that comprise it. The larger the company, the more influence it exerts on the index’s performance and volatility. A small number of larger companies can effectively dominate the index, crowding out the other constituents, thereby reducing the index’s ability to accurately reflect the broader underlying health of the marketplace. Currently, the largest five companies in the S&P 500 (Nvidia, Microsoft, Apple, Google, and Amazon) comprise 29.1% of the index, which is equivalent to the weighting of the 414 smallest companies in the index combined.[ii] These same five companies far outweigh the aggregate of the Real Estate, Materials, Utility, Energy, Consumer Staples, and Industrial sectors.[iii]
The weighting system of the S&P 500 thus can create distortions in what the index is intended to represent: the underlying health of business conditions in a broad swath of large U.S. companies. This distortion, from the perspective of an index investor, can be temporarily beneficial as good performance in a few stocks may outweigh lackluster performance elsewhere, such as Q2 in 2024 when the S&P 500 returned a healthy 4.3%, despite 296 component companies posting negative returns.[iv] The top five stocks accounted for a 4.7% return (109%), meaning that the other 497 companies had a negative .40% cumulative return for the quarter![v] (No, there are not exactly 500 stocks within the S&P 500.) The median quarterly return of those other 497 companies was an incomprehensible -3.4%.[vi] We can double check this observation using a short-hand method. Reshuffling the same companies within the S&P 500 such that each company is equally weighted, we see that the index would have returned -2.6% for the second quarter, a massive difference of 6.9% from the more widely followed capitalization-weighted version.[vii]
Late in the second quarter, the S&P 500 rose for five straight days while market participation (the number of stocks rising compared to the number of stocks falling) declined. This five-day streak tied the record set in April of 1999 and surpassed two other instances of four consecutive day streaks in April and September of 2000.[viii] Given this perspective, it becomes more difficult to confidently say that the U.S. is in a bull market when the average stock fell in the second quarter and only five stocks drove more than the entirety of the positive return.
In addition to obfuscating returns, capitalization-weighted indices can mask underlying volatility. The S&P 500 has enjoyed 338 trading days without suffering a 2% daily decline, the tenth longest streak since 1928. During this time, the index registered fifty-six new highs, a feat previously only accomplished two other times in the last century.[ix] Additionally, during the NASDAQ’s record setting run in June, where the composite hit an all-time high in nine of ten consecutive trading days, more stocks actually tagged yearly lows than highs. In the last forty years, the only such similar cluster was in October/November of 2007.[x] June’s record setting run culminated with an all-time closing high on the 14th, which unceremoniously showcased 72% of NASDAQ stocks closing with negative returns, and twice as many new lows as new highs for the year.[xi] As you may have guessed, the NASDAQ is also capitalization-weighted.
These observations do not portend a significant market event. As noted in previous commentaries, near record government spending should help buoy risk assets. It does suggest that a rotation from technology into other areas of the market could be forthcoming. Since the late 1990s, there have been different leaders during each market cycle with technology stocks, emerging market stocks, commodities, developed international stocks, value stocks, and small caps equities each taking turns as the top performers. Each cycle has had seemingly invincible market leaders and a menagerie of reasons for why the party should never end; but the party always did. To emphasize how drastic this change in leadership can be, from the peak of the tech mania in March 2000 through the peak of the next bull market in October 2007, small caps, international developed stocks, the Bloomberg Commodity Index, the S&P 500 Value Index, and the equal weighted S&P 500 returned, 61.8%, 64.4%, 76.7%, 59.3%, and 82.6%, respectively; meanwhile, the S&P 500 returned just 16.1% over that period.[xii]
In summary, the last time such extremes in breadth and participation in the S&P 500 arose, the next seven and a half years beheld the dominance of many other asset classes and lackluster returns for the S&P 500. This was an outcome most investors at that time would not have imagined, just like they are not likely considering it today for that matter. Similarly, many commodity bulls could never have envisioned a twelve-years-long commodities bear market beginning in 2008 after the massive decade-long bull market that preceded it. History is clear that no market cycle continues forever, but it is also clear that dislocations such as this current one can continue for an uncomfortably long time. Rather than chase five tech stocks, we actively choose to stay true to our discipline, trust our process, and open ourselves to the possibility that tomorrow might look much different than today.
We hope you have a great summer, and warmly invite you to reach out to us should you have questions or would like to get together.
Regards,
Peak Financial Management
Disclosures:
The views expressed represent the opinions of Peak Financial Management as of the date noted and are subject to change. These views are not intended as a forecast, a guarantee of future results, investment recommendation, or an offer to buy or sell any securities. The information provided is of a general nature and should not be construed as investment advice or to provide any investment, tax, financial or legal advice or service to any person. The information contained has been compiled from sources deemed reliable, yet accuracy is not guaranteed.
Additional information, including management fees and expenses, is provided on our Form ADV Part 2 available upon request or at the SEC’s Investment Adviser Public Disclosure website – https://adviserinfo.sec.gov/. Past performance is not a guarantee of future results.