Records left and right

The S&P 500 index hit a milestone last week. The index finally exceeded its 19 February peak after weeks of flirting with the 3,386.15 record level. The S&P 500 first closed above February’s record high on Tuesday, before wavering and falling back below that level in subsequent sessions. The index made a bid for the all-time high again on Friday, and successfully closed at a new all-time peak of 3,397.16, 10 points higher than the 19 February record close.

With just 126 trading days separating the peaks in February and August, this is one of the fastest recoveries from a bear market on record. It is the third fastest rally to offset the full drawdown experienced during the lows in March, just behind the 1982 and 1990 rallies that took about three and four calendar months respectively to recoup all losses.

In addition, the bear market between 19 February and 23 March this year was also the shortest on record, lasting about 23 trading days. Reaching a definitive low in equities this early in a recession has no precedent. Typically, the equity market reaches its trough months after a crisis begins, and the slow grind lower tends to be paved with mini-rallies and sell-offs along the way. By contrast, the coronavirus sell-off was steep and quick, and its recovery equally impressive and swift.

As it stands, the S&P 500 index is up more than 5% year-to-date. It is all the more remarkable that this record-setting climb has happened against a rather dour economic backdrop.

Driven by the few, not the many

Admittedly, the rise in the S&P 500 index has been driven by a narrow base of stocks. Year-to-date, close to 60% of the stocks in the S&P 500 are still trading in the red. Last week, the S&P 500 index ticked 0.32% higher on Thursday, driven primarily by the rise in 156 stocks out of the 505 companies represented in the index. Essentially, the one-day increase in the market gauge was driven by 30% of the stocks in the index.

The same was true on Tuesday when the index first hit a fresh record high. The S&P 500 gained 0.23%, thereby exceeding the 19 February peak, but only about 34% of stocks in the index rose that day. Typically, a healthy and sustainable market rally is one that is broad-based, one that includes a wide swathe of stocks rising together – a wide market breadth – propelling the broader index higher. This is clearly not the case in the current market situation.

Comparing the S&P 500 index (market-cap weighted) with its equal-weighted cousin and a version of the index with the information technology sector stripped out, we find that the variants of the broader market gauge are still under water year-to-date, which reflects two key observations.

• First, technology stocks have been broadly responsible for the rally.
• Second, the broader S&P 500 index is heavily weighted in sectors that have done exceptionally well during the crisis and in companies that have seen its market capitalisation balloon during this period.

Tilted to the winners

It is common knowledge by now that the rise in the S&P 500 has been turbo-charged by mega-cap technology stocks like Facebook, Apple, Amazon, Alphabet and Microsoft. Apple, for example, made news becoming the first two trillion-dollar company in history, during a deep recession no less. Together, these five companies collectively comprise more than 20% of the S&P 500 index and the returns on their stock year-to-date have been nothing short of exceptional. Because of their sheer size and heavy weights in the S&P 500 index, the performances of these stocks hold tremendous sway over the entire market.

More generally, growth sectors like information technology and health care, whose activities are less affected by the coronavirus, hold a fairly large weight (~42%) in the S&P 500. Value and cyclical sectors, that are still weighed down by a challenging macro-economic environment and an uneven economic recovery, carry smaller weights in the index. Hence, the index is tilted more towards the winners of the pandemic and is less representative of the overall macro-economic environment.

Of course, the performance of the S&P 500 is chump change in comparison to the dizzying rise of the tech-heavy Nasdaq Composite index, which hit 36 new successive record highs just this year alone, and is up about 25% year-to-date, five times the performance of the S&P 500 index across the same time frame.

Obsessed with tech

The obsession with tech is understandable given that these companies are poised to thrive in a stay-at-home economy and will likely emerge from the crisis with a stronger competitive position.

Mega-cap names like Apple, Amazon, Alphabet, Microsoft and Facebook have expanded their market share over the years and are now reaping the benefits of their dominant positions in businesses that have become crucial to a technologically sophisticated and interconnected global economy. These companies are the clear leaders in areas such as online advertising and search, social media, online communication platforms, operating systems, office software, cloud computing, e-commerce and so on. These digital services carry immense importance especially during the time of coronavirus, where social distancing is the new norm.

Their immense cash reserves have also allowed them to acquire potential competitors before they grow large enough to present a real challenge to their market dominance. Facebook folded WhatsApp and Instagram into their sprawling portfolio of communication apps, while Microsoft bought Skype and later made a bid for the US operations of TikTok.

The pandemic has only accelerated secular trends that will fuel the continued growth of these companies. For one, digitalisation is no longer just an industry buzzword, but a business imperative. Luddites became digital believers, and believers became technology’s most ardent proponent yet. The pandemic has hastened the shift from offline to online channels in almost all aspects of business from e-commerce to communications and entertainment, bringing a broad set of businesses into the orbit of these tech giants which possess a comprehensive product suite to aid in this transition. Meanwhile, their huge cash pile provides ample leeway to expand operations or entrench their market positions further by acquiring weakened tech players.

Lofty valuations have not turned investors away from tech and do not necessarily imply that we are in bubble territory. In fact, Wall Street remains obsessed with the sector and for justifiable reasons. Investors continue to lust over the fortress-like profit potential of these mega-cap tech companies, which are supported by solid balance sheets, huge cash reserves and a product suite tailor-made for a stay-at-home economy. Indeed, the growth trajectories of these tech juggernauts are leveraged to multi-year secular trends that have only been accelerated by Covid-19.

Healthy fundamentals including solid balance sheets, vast cash reserves and bright secular growth prospects are conditions that were not necessarily in place back during the dot-com bubble of 2000. On balance, while concerns about steep valuations are valid, fears of a bubble seem somewhat premature at this point.

There is no alternative

Broadly, the record climb in equities should be viewed in the context of a market environment that is flushed with plenty of liquidity and central bank support, delivered at a speed and scale that is unprecedented compared to past recessions.

The Federal Reserve expanded its balance sheet by more than US$2.8 trillion dollars in just a few months. Much of the money created has been used to buy US Treasuries and mortgage-backed securities. The central bank has also effectively back stopped US corporate bonds, having set up a separate facility to purchase individual paper. They have also expanded liquidity support to at-risk businesses via the issuance of trillions of dollars in emergency loans. Save for buying equities outright, the Fed has essentially backstopped risk assets.

The explosion of broad money stock suggests that equity markets might continue to stay elevated as these funds search for a resting place. With long-term US Treasury yields trading at about 60 to 70 basis points and inflation-protected bond yields trading in the negative, there are admittedly limited options for investors seeking to grow their stash of cash besides equities.

While price-to-earnings valuations for US equities look particularly stretched, other valuation measures such as the equity risk premium and yield gap remain above long-term averages, which suggest that, on a relative basis, stocks are still offering better returns.

In a sense, for investors, there are few alternatives beyond stocks for those looking for inflation-beating returns. And within the equities space, it seems reasonable to expect that these investors will continue to favour the obvious sector winners of this pandemic, namely tech and health care players.

Yet, this does not mean becoming bullish for bullish sake. Extended valuations underscore the need to be more cautious particularly because the margin for error is compressed.

We are not working off a low base and the bar for further upside is admittedly higher. We can take comfort in the flood of liquidity but at some point, we will reach a “show me the money” moment in which economic fundamentals and company earnings must somehow validate the price being paid for a discounted stream of future earnings.

Pay attention to the risks

Indeed, the US stock market is priced for perfection. As it stands, on a 12-month blended forward basis, the S&P 500 index is trading at price-to-earnings multiples more than 2 standard deviations above its past 10-year historical average.

But this also means the US stock market is dangerously exposed to risks. It could be vulnerable to another drumming should risk factors emerge and challenge prevailing expectations of a quick economic rebound or should there be disappointments or speedbumps that delays the discovery of a credible vaccine.

In the climb higher, investors have conveniently glossed over a number of risks that lie ahead. There are three important ones to consider:

• The first and the most prominent of these is the current stimulus stalemate. The inability of lawmakers in Washington to cobble together a bipartisan, fresh stimulus plan might have adverse consequences on the stalling economic recovery and potentially unravel expectations of a quick economic rebound.
• Escalating US-China tensions is yet another risk factor markets have conveniently ignored. Conflict between the two countries have broadened in scope, expanding into areas beyond just trade, including heath care, technology, investments and geo-politics. This will have long-standing operational implications on companies that have a business presence in and derive revenues from China.
• The third is the US presidential elections come November. With markets at record highs, uncertainties related to the election is a potential catalyst for market volatility ahead. An analysis of the S&P 500 since 1928 show that equity market volatility tends to increase 30% on average from July to November in election years.

So far investors have been willing to shrug off these concerns and focus instead on earnings and economic data that have mostly trounced overly depressed expectations. After widespread lockdowns in the second quarter, we should not be surprised that simply turning on the lights again will inevitably result in an initial sharp spike of growth from an extremely low base. The danger lies in extrapolating this initial sharp bounce to a complete V-shaped recovery. Ultimately, the path of the global recovery remains highly uncertain and is heavily dependent on ongoing policy support. Given these risks, the stock market’s climb higher might become more difficult moving forward as risk factors come into focus.

Potential concentration risks in certain indices

Beyond these risk factors, investors should also note potential concentration risks inherent in exchange traded funds (ETFs) that track the S&P 500 index. Because there is a relatively high concentration of mega-cap tech companies in the S&P 500, price movements in the aggregate index could become more sensitive to risk factors that affect the tech sector or these companies more specifically.

Key risks affecting the tech sector include increased regulatory scrutiny, stronger anti-trust pressures and tax policy implications arising from a potential Democratic sweep of the legislative and executive branches of government come the US presidential and congressional elections in November this year.

A marked shift in the policy environment towards tougher anti-trust enforcement, rollbacks in laws granting immunity and protections for content moderation, increased investigations of abuses of market power and overall increased regulatory scrutiny may spell trouble for the tech sector. As it stands, the rising influence of Big Tech shares bipartisan concern, yet legislative action has been slow. A new administration might just speed up this agenda. This might not be a pressing near-term problem, but political rhetoric on these matters could easily spook markets.

Susceptible to swings in market leaders

Also, investors should be aware that a rally driven by an increasingly narrow base of stocks – a narrow breadth rally – is historically correlated with large market drawdowns. They tend to occur for two reasons.

• First, investors sold-off market leaders on signals that these companies were unable to generate sufficient fundamental earnings to justify stretched valuations and investor crowding, hence triggering a ‘catch down’ to their weaker peers.
• Second, an economic recovery and broadly positive investor sentiment may have led to profit taking and rotation out of crowded trades into laggards, helping these stocks play ‘catch up’.

In both scenarios, market leaders would register an underperformance relative to their laggard peers. As it stands, the second scenario seems most probable, but it might take stronger evidence of a durable economic recovery to trigger a more sustained rotation from growth to value and cyclical stocks.

Curb your enthusiasm

With these risk factors in mind and in view of record high stock markets, it might be an opportune time for investors to review their portfolios. With equity markets climbing ever higher on an increasingly slim base of stocks, it is best to curb one’s enthusiasm just for a minute and review portfolio positions before engaging risk.

The first order of business is to ensure portfolios are well diversified across asset classes, regional markets and sectors. This is to ensure portfolios are resilient enough to withstand more turbulent market conditions expected ahead.

In terms of sectors, investors with outsized exposure to growth sectors such as health care and tech, may consider rebalancing their portfolios into cyclical and value stocks in sectors such as financials, real estate, industrials and materials. Companies with resilient balance sheets and stable business models may benefit from a growth upswing as the global economy gradually recovers.

In the wake of the current widening gap between growth and value stocks, it might be prudent for investors to rebalance their equity portfolios and rotate into value and cyclical stocks. The lower for longer interest rate environment also favours a dividend-focused strategy.

For those who are underweight tech and other high growth sectors, there are still opportunities to increase exposure to growth stocks. However, given that these stocks have rallied quite a bit since the lows of March, investors should tread this path carefully. Selective stock-picking matters amid steep valuations. Engaging growth sectors through actively managed diversified thematic portfolios is one way to increase exposure to these sectors in a somewhat less risky manner.

In terms of regional exposure, there are opportunities in relatively less steeply valued markets such as Hong Kong and Singapore. Investors should actively ensure portfolios are adequately diversified across different regions to avoid home bias in portfolio construction and to reduce concentration risks in any one regional market. In this regard, funds with global exposure are useful additions to portfolios to improve geographical mix in a cost-effective fashion.

In terms of asset classes, investors with heavy exposure in equity ETFs and actively managed unit trusts should also consider high quality bond funds as a source of asset class diversification and income. Global multi-asset income funds with exposure to less conventional asset classes might be useful to improve asset class diversification and expand potential sources of income.

Also, with markets expected to stay volatile ahead, investors may consider diversifying their market entry via a dollar cost averaging approach.