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There’s something strange about stock market concentration: Morning Brief
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The major indices may have registered only small gains on Wednesday, but while the generals slept, the soldiers marched.
At the forefront, moderate losses at big energy and financial companies were offset by outsized gains in the consumer discretionary sector – thanks largely to Amazon (AMZN) and Tesla (TSLA).
This seesaw theme has become a subtle but important market narrative. On days when AI isn’t leading the charge, certain pockets of strength prevent the S&P 500 from more pronounced sell-offs – which in itself is keeping the index’s volatility near multi-year lows.
Nvidia’s recent “dive” is instructive.
On Monday alone, the AI poster child closed down 13% from its record high. Scanning social media, you would think Wall Street was on fire.
But during that harrowing three-day crisis, a funny thing happened: the Dow Jones Industrial Average (^DJI) – up just 3% this year, versus 14% for the S&P 500 – has staged a recovery. Energy perked up and biotechnology jumped as forgotten areas of the market showed signs of life.
This offsetting behavior is everywhere right now, rather than correlations between stocks in similar sectors. Stocks simply don’t want to move in the same direction.
“This is a generationally weird American stock market,” wrote Luke Kawaformer director of investment solutions at UBS Asset Management Americas, now at Sherwood Media.
Kawa was specifically referring to Tuesday’s price action, in which the S&P 500 managed a 0.4% gain despite 384 of its components closing in the red – a new feat for a data set that dates back to 1996.
Similar “firsts” have been dotting the market statistics recently.
But none of this detracts from the argument – supported by extensive research and history – that it is perfectly normal in a bull market to have gains concentrated in a few stocks.
Winning stocks that enjoy a secular-themed rally get bigger and bigger until the movement runs its course.
In a bull market, when major stocks falter, other parts of the market that may not be generating hype-filled headlines can rise to the occasion. Sector rotation keeps index-level volatility low as new winners offset losers. And then, at some point, the music stops and all sectors start selling off in unison, ushering in a new bear market.
Kawa linked this to the current market, writing this “Different large groups within the US stock market have recently been marching to the beat of their own drums, and this dynamic has helped keep the stock market from falling violently to the downside.”
The story continues
Today, we are not only seeing disparate returns across sectors and industries, but also within them – even in mega-cap technology stocks. In the last six months, if some of them, such as Microsoft and Alphabet, rise, Nvidia and Apple may fall. The correlation between directional movements between peers in this cohort is just 43%, Kawa noted.
All this zigzag movement keeps the index’s volatility in check, but Kawa exposes The main risk in this environment: a “correlated shock” that is distributed “among these companies that control a large part of the US as well as global stock indexes”.
While the “big dip” remains the focal risk, divergences may persist longer than arbitrage investors can remain solvent (to turn a old Wall Street trope).
In fact, research by BofA’s data analysis team suggests that the current regime of low inter- and intra-sector correlation could persist for years.
Stock correlations in the S&P 500 are at historic lows.
“Several years of decorrelation in the 1990s as the Internet bubble developed suggest that the persistence of today’s regime remains a risk,” BofA wrote.
Consequently, the outsized bifurcation in returns between the AI-chosen few and the rest of the market need not end with a bang.
“Just because we’re in uncharted waters doesn’t mean we’re heading toward a waterfall. It could end up being a lazy river,” Kawa wrote.
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