Stock averages marched higher in 2024’s first half, overcoming interest rate headwinds and inflation fears with the help of a speculative boom focused on Artificial Intelligence. Some market participants—specifically index fund owners and tech stock enthusiasts—saw their portfolio values expand nicely during the six-month period; other investors experienced more modest gains.
The word “some” reflects a key reality in today’s financial marketplace. We have previously commented on a development that has shaped the perception of general market conditions in recent quarters, namely the concentration of attention on a small number of stocks in the tech sector and its impact on capitalization-weighted indexes. In cap-weighted indexes, such as the S&P 500 or NASDAQ, companies with the highest market values have the greatest impact on the index and its fluctuations and trends. These favored-company stocks also tend to be the most popular, most widely owned, and most expensive issues in the entire equity universe. Apple, Microsoft, and Nvidia are among these “big tech” names, and all are associated with AI, the latest Wall Street fad. Excitement over AI has inflated the prices of these stocks—along with those of other tech companies—and, curiously, a few normally staid utilities (the computing power required for AI demands a lot of electricity).
This trend persisted into the second quarter with a vengeance, as only three high tech companies (the very ones mentioned above) accounted for 90% of the S&P 500 index’s return of 3.9%. By contrast, an “equal-weighted” version of the index—in which each component contributes equally to the market barometer’s changes—actually declined, by 3.1%. In the year’s first half, the standard index rose 14%, with 60% of the move driven by the action in only five stocks, all tech. The equal-weighted index rose just 4% in this same period. It is not as if the broader market was a huge disappointment for shareholders—in the late 1990s, also characterized by a very concentrated, tech-driven stock market, most stocks declined sharply while the averages raged onwards and upwards—but the gains for most stocks were not what the averages would lead you to believe.
While we find these kinds of market dynamics to be curious and mildly entertaining, we do not ascribe any special predictive power to such analyses. Nor would we pay much heed to this phenomenon were it not for the fact that most people are aware of only a few index figures and do not understand how they are calculated. This lack of understanding can lead to disappointment among the investing public and poor choices. It also makes for cramped decision-making among investment professionals, who, though fully aware of how Wall Street works, are compelled by competitive pressures to embrace and adapt to industry realities whether they like it or not.
In the grand scheme of things, these market behaviors represent transitory pattern of ebbs and flows that eventually reverse themselves. This pattern is significant primarily for the volatility it can induce as interests change and focused bets unwind. Some observers see risks in the market’s narrow “breadth,” but a sharp reaction is not inevitable. While heavy concentration in 1929 and 1999 preceded historic market declines, there is no reason why this should be today’s fate. “Lagging” stocks gaining as leaders return to earth is one scenario that could result in a healthier market environment. Instead of disaster, the market could work through its imbalances; something of this sort has played out over the past several months as some long-disfavored sectors have perked up. Although a small number of issues remains the primary object of interest today, nothing is for eternity.
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Sometimes we wonder how humanity has managed to survive for the minute slice of geological time that has so far been allotted to us. Perhaps our genes were shaped, and habits honed, during times when our existence was a day-to-day affair, and long-term thinking was confined to gestation periods. Life in civilization requires consciousness of, and planning for, the future. In the past, powerful institutions and belief systems provided a bulwark against the tyranny of the fleeting moment’s concerns; those protections seem to have eroded. Even after a devastating pandemic, many in positions of responsibility can’t bring themselves to make the investments necessary to detect and deal with a future catastrophe of this sort. On an individual scale, few of us contemplate the long-term consequences of our actions.
History shows that those able to take a long view have a decided advantage. Groups with strongly held beliefs and aims who engage in a relentless pursuit of those goals over years, even generations, often succeed. Unswayed by short-term setbacks, they pursue a “long game” and march forward undeterred. The ten-year march to power by the Nazis in Weimar Germany comes to mind, as does the decades-long packing of courts with partisans. Such moves may go almost unnoticed by the greater society, until it unexpectedly finds itself subject to the will and agenda of a determined minority.
The advantages of long-term strategies pursued with determination accrue to investors as well, though hopefully with more positive outcomes. Those choosing to play a long game, ignoring noise which passes for news and favoring facts over the clickbait attitude of Wall Street, take advantage of “time arbitrage” to benefit from temporary disruptions. Short-term calamities can become long-term gains if one looks beyond present difficulties. Setbacks are seldom for an eternity.
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It is a dangerous sign when members of the public come to view stock trading as a way to earn a second income. We last came across this misguided attitude a couple of years ago amid the “SPAC” speculation. SPACs (Special Purpose Acquisition Companies) sold shares to the public based solely on managements’ claims that with the money so raised they could find a business to buy and run profitably. Few prospective SPAC shareholders were aware that very similar schemes were popular in the 1920s speculative fever. Like their predecessors, most SPACs floundered (although those promoting them made gobs of money).
In theory, a capitalist economy employs financial markets as engines of capital allocation—connecting owners of capital with seekers of funding—for investment in productive capacity, or for making possible the realization of new business ideas. Yet often it seems the markets act to misallocate capital, funneling money to projects of dubious societal or economic value. As in the SPAC case, many who plough money into new market issues find themselves subject to dreadful losses. Hence, it has long seemed to us that the markets are great capital allocators—to selling shareholders(original investors in pre-public companies who sell their positions, in whole or part, in an initial public offering).
It is also not a good sign when shares are offered by motivated sellers , as selling shareholders certainly are. Motivated sellers aren’t known to sell when prices are low, which is why we find it difficult to suggest than a person buy stock in a new offering. It is also why we believe that from the investor’s perspective, the secondary capital market is the most important component of the financial markets. The secondary market is where securities are traded after their initial issuance, where price discovery and signaling take place, and where issuers develop a history of business performance in response to the vicissitudes of the business world. In short, it is where securities become seasoned and thus more analyzable. The market for new issues (the primary capital market) plays off the secondary market—for example, excitement about existing AI stocks may embolden new companies in the field to raise capital in an accepting market environment—but it is in the secondary market where the most interesting action takes place.
As investors we are primarily interested in the price signaling function; large price drops pique our interest, for example. The markets, as a meeting place for human actors, are subject to human emotions, and the fear of losing wealth is one of the most powerful, which is why sudden declines often precede a frenzy of selling at even lower prices. Although a declining market value may very well reflect the reality of a business in trouble, it could also create opportunity for those who do their due diligence and play the long game.
Dennis Butler, MBA, CFA
Commentary