Submitted by Chris Metli, executive director in Quantitative Derivative Strategies at Morgan Stanley
Fed ‘liquidity’ has powered the S&P 500 to a 16% gain since they announced Permanent Open Market Operations in October 2019, while the NDX is up a cool 26% (total returns). The rally makes sense in the context of a Fed that is continuing to print money until at least April, and beyond that likely continues to try to fight the structural forces of deflation with the only tool they have. But at the same time consensus is that the rally in Tech/Growth continues, and investors should be increasingly concerned with some of extremes being priced into markets.
The below is a non-exhaustive list of data points that highlight just how crazy some things have become. In this environment adding beta or Growth/Tech exposure carries too much risk in QDS’s view. Instead investors should consider rotating out of their most stretched single-stock positions and into call options (i.e. stock replace, keeping upside but limiting downside), or hedging the most vulnerable areas of the market – Crowded stocks (MSXXCRWD) or Growth vs Value (MSZZGRVL). See last week’s Factor Volatility is Here to Stay for details.
Turning to the data – first consider that breadth over the past six months has been the narrowest since at least 2005, with only 38% of S&P 500 constituents outperforming the index.
Low breadth has pushed the concentration of market cap within the S&P 500 to the highest level since at least 2005. US Strategist Mike Wilson has highlighted that the five largest companies are all Tech names and currently make up 18% of the S&P 500 market cap, but less than 14% of the total S&P 500 earnings (see US Equity Strategy Weekly Warm Up: Concentration Should Lead to Opportunities from Jan 13th 2020). Taking a broader measure of concentration (the HHI index = the sum of squared weights) shows that overall concentration of market cap is this highest since at least 2005. Even more extreme is the sector concentration, which has been steadily rising since 2019 but has gone parabolic in the past few months.
Options investors are not being left out either, with investors spending more premium buying new single-stocks calls over the last two weeks than at any point since at least January 2018. Note that previous peaks of new premium spend in calls versus puts were just before the Feb 2018 and Oct 2018 selloffs. Much of the activity in options has been in Tech, Communications, and Discretionary stocks (yes TSLA, but the increase in activity is broader than that), and the notional volume of calls relative to puts in these sectors has reached historical highs.
The outperformance of Growth versus Value is greater over the last 3 months than at any point since May 2008. This divergence in performance is pushing Growth versus Value valuations wider, and the dispersion in valuations across the Russell 1000 is now the highest since 2001.
Yes, the Tech bubble was worse on many metrics – Tech and Communications were over 35% of global market cap then versus just 25% now, and this bubble could keep growing. But the fact that the Tech bubble is increasingly becoming the relevant time period that people are comping to is in and of itself concerning…
This concentration in Tech and secular growth names reflect a continuation of the massive flight to quality on the back of expectations for middling economic growth but an easy Fed. There are signs of instability in the market (in particular regarding factor volatility and correlations – see QDS’s Factor Volatility is Here to Stay Feb 14th 2020) which means that the bar is lower for a violent unwind of crowded positioning. While most of the sector and factor themes are highly correlated (Growth vs Value, Large vs Small, Defensives vs Cyclicals, Winners vs Losers, etc), Growth vs Value (MSZZGRVL) and Crowded stocks (MSXXCRWD) are the most at risk in QDS’s view.