This Market Is a Tech Market. If Bond Yields Rise, Watch Out.
There is danger in a market overly reliant on a group of companies that are so similar
There has been a lot of concern recently about the stock market being top-heavy, dominated by just a handful of companies, and that this might spell trouble for future returns. But really what we should worry about isn’t that the market is reliant on a few stocks. It’s that the market is reliant on a few very similar stocks.
The five biggest companies today—Apple, which passed $2 trillion in market value this week, Amazon, Microsoft, Alphabet and Facebook —make up 25% of the market value of the S&P 500. That is the most since 1970, but stocks managed a stellar performance during the 1960s despite being even more top-heavy. The difference is that in 1970 the biggest companies did quite different things: computers ( IBM), telephony ( AT&T), car making ( General Motors), oil ( Exxon ) and cameras ( Kodak ).
The danger now is that the market is overly reliant on a group of companies that are all a bet on disruptive innovation—the big five and a wider circle including other fast-expanding growth companies such as Netflix and Nvidia. They have thrived since the pandemic began because so much of their lifetime profits lie far in the future, meaning their valuations benefit from low rates while short-term pandemic-related hits matter less.
Anything that hurts this group could drag down the wider market, even if other stocks are fine. And because this group has done so well from low bond yields, it should be especially susceptible to pain if those yields were to rise.
Earlier this week highlighted how two types of rising yields could be a risk for the broader market.
The first risk is that yields go up because the economy is healing. The opposite happened on Tuesday, when bond yields fell as investors became more cautious about economic recovery. Not surprisingly, twice as many stocks fell as rose, and the average stock fell. Yet the S&P 500 passed its February high because the ones that did rise were far bigger: the 168 gainers on the day averaged a market value of $103 billion, while the 332 losers were worth an average $40 billion.
Reverse this position, and it is easy to see how improving economic optimism could result in the market as a whole falling. The average stock should still go up, but the top-heavy nature of the market will leave more big stocks exposed, and so could drag down the S&P.
The second risk is that yields go up because the Federal Reserve becomes more hawkish. Earlier this week we had a dry run when the Fed minutes disappointed many hoping for explicit guidance on rates soon. Investors changed their view on how the Fed will react in future, and stocks dropped—with the biggest falling by more than the rest. Growth stocks underperformed, but the mass of the rest did badly too, with again twice as many losers as winners.
I don’t think the Fed is likely to abandon its super-dovish stance any time soon, despite Wednesday’s minor disappointment. And while I would love to see a V-shaped economic recovery lift bond yields, the obstacles are huge. My reason for raising this issue now is that the price moves of the big stocks and the rest have begun to diverge much as they did in advance of several prior corrections—as the relationship between stocks and bonds has begun to shift.
The simplest way to compare the moves of the big stocks and the rest of the market is to look at the correlation between daily rises and falls in the ordinary capitalization-weighted S&P and the equal-weighted version. When the market is working normally the two are closely linked, but when the biggest stocks move differently from the rest they have more effect on the ordinary S&P than the equal-weighted version, so the correlation falls.
The correlation fell sharply in the late stages of the dot-com bubble in 1999 and 2000, the housing bubble in 2006, the volatility bubble of 2017 and the excesses before the recession fears of late 2018, and it has fallen sharply again. When the biggest and most fashionable stocks start behaving differently from the rest, it is often an early warning that things are getting out of kilter, although it may be months before trouble becomes obvious.
The stock-bond correlation hasn’t moved as much, but suggests that the big tech stocks and growth stocks are becoming much more sensitive to bond yields than the rest of the market. Short-term correlations are volatile, so this could quickly return to normal. But if the trend continues it would threaten a pattern of higher yields typically being good for stocks that has been in place since the early 2000s.
It’s too early to say that things are going wrong, and certainly this is not evidence of a bubble. But it wouldn’t be a surprise that a market reliant on central bank and government support should be threatened by rising yields, even when they start out so low.