S&P 500: Champions and Losers

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S&P 500: Champions and Losers

MARKET INSIGHTS
03 Mar 2022

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Institutional investor concerns about the U.S. equity market being overvalued have been around since 2017. Despite a large percentage of institutional investors buying into top-line stocks such as Tesla and Amazon, this concern hasn’t really subsided. Surveys reported that most Fortune 500 CFOs and fund managers held this belief in 2020. Mr. Charlie Munger, Vice Chairman of Berkshire Hathaway, reiterated this belief in 2021 and added that the market will (or should) correct soon.

Given recent performance of the S&P 500, some might arrive at the quick conclusion that there is every indication of a recession being anticipated. However, a long-term study of trends in individual securities and sectors highlight that this is not the case: market corrections are aiming for a reset in the overvaluation seen in some key sectors and stocks.

Rises and Drops

Let us consider yearly horizons starting from November 2019 till 2021, with an additional window till the 25th of February 2022. The index is analysed via the holdings of S&P 500 ETF (SPX). The contribution of each security within SPX to the total movement of the SPX is estimated and termed the “Contribution Index” and the total change in stock price within each window is termed the “Price Delta”.

The Top “Rise” and “Drop” Leaders as per the highest and lowest “Price Deltas” yield some fascinating results:

Based on the deltas, it could be implied that movement restrictions had propelled Amazon and Netflix to a massive year-on-year delta by the end of 2020. Added to this were the concerns over the pandemic that drove pharmaceutical and diagnostic companies to high deltas as well. Meanwhile, companies associated with travel and energy companies had significant drops. By the end of 2021, it could be implied that Alphabet’s steady growth was the fuel that drove the index while pharmaceutical companies began to drag. In the months since November 2021, however, construction, energy and food companies had massive rises while “tech” giants such as Amazon, Alphabet and Tesla were collapsing.

But why is the S&P 500 collapsing? This is attributable to the weighing schema: “Tech” companies have very high weights and an outsized effect on the index. Thus, even when the stock price upticks in these types of companies were minimal, the index would go up. By the same token, when these stocks slip, it gives the appearance of a massive fall. For instance, in the November 2019-20 window, Amazon, Alphabet, Microsoft and Apple is estimated to have contributed about 60% of the uptick in the index while in the three-month window between November 2021 till February, these same stocks have contributed to 59% of the downturn seen in the index.

In holistic terms, while a number of “non-tech” stocks have been rising in the three-month window, this has little to do with the economy. While it is true that the US economy is facing 40-year highs in inflation, what’s also true is that nearly every major stock in every major industry is massively overvalued and there is every indication that this is being corrected.

The Ratio Squeeze

Ratios form multi-dimensional boundaries when it comes to instrument indicators. In itself, no stock should in theory be valued too high relative to others in its industry or classification. In practice, this has not been the case. Given the fact that US Treasury yields have been too low to guarantee “safe harbour” from inflationary rises for the past 20 years and more, there has been a “crowding effect” in other public markets such as equities. Narratives on new technology and over-optimistic impact on market share have rarely translated into real-time eternal dominance which, in turn, means that projections reflected over a long-term horizon becomes more and more speculative.

Let us consider the Top Two overweight and underweight in terms of one ratio – the Price-to-Earnings (PE) Ratio – for each industry classification at the start of each window period all the way till February 2022.

In recent times, the likes of Disney, Twitter and Hess Corporation are overweight relative to their industry medians while the likes of Citi and General Motors are underweight. What’s most interesting in the short-term window spanning November 2021 till January is that, in nearly every case, while the champions’ ratios are dwindling, the median ratios are rising slightly or holding steady. This suggests a strong diversification move.

In some cases, the ratios are egregiously high: Disney is at nearly 70 relative an industry median of around 24 while Tesla is 166 when the industry median is around 17. In an interesting bit of forecasting, Goldman Sachs’ strategists had predicted that the S&P 500 will likely net about 9% in gains for 2022. Given the diversification being seen, it can only be assumed that a net reallocation of capital from overweight stocks in each industry classification to those considered underweight is underway.

Note: The terms “underweight” and “overweight” are being used relative to industry median. There are plenty of arguments to suggest that even industry averages and medians are too high. On a practical basis, however, it should be assumed that no stock will come to rest anywhere close to ideal ratio efficiency any time soon. In other words, while ratios can be expected to be optimistic in the forward-looking horizon, it will be less unrealistic. Ratios of 70 and 166 simply lend more volatility to the stock trajectory, which cannot be assumed to remain eternally upward.

In Conclusion

The multidimensional “ratio cool-off” seen in recent times and the possible reallocation of capital highlights the possibility that market players have begun adopting a paradigm that is long overdue. Overvaluation leads to stock volatility that impacts the stability of long-term portfolio management. But it bears noting that the decay wouldn’t be a smooth one precisely because of overvaluation: any seemingly meaningful news about top-line stock results in short-term “bump” or “drop” followed by a correction. Nonetheless, as a whole, trends in apparent capital reallocation and ratio decay in this overvalued market would likely continue over the year.

On the tactical front, it is entirely possible for European investors to make plays without diminishing their existing holdings to take advantage of any short-term trajectory in top-line stocks in both directions. A variety of single-stock exchange-traded products (ETPs) built on top of leading “high-conviction” stocks that are seeing this decay are available across European exchanges and brokers to make a play on the downturns. A number of ETPs based on leading ETFs are also available. With new tools in the arsenal, it is now possible for traders to benefit from short-term trajectories while keeping intact their holdings in high-conviction stocks – if they choose to.

Your capital is at risk if you invest. You could lose all your investment. Please see the full risk warning here.

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Sandeep Rao

03 Mar 2022