Weekly Update - The Japanese Whale, or the Retail Shoal?
In recent years, Information Technology has become the largest single sector in the US equity market, currently accounting for 28% of market capitalisation. Moreover, a number of large companies often considered as tech stocks now sit in other sectors.
For example, Amazon, which accounts for 5% of the S&P500 index, is now classified as a Consumer Discretionary stock while Facebook (around 2.5% of the index) is included in Communications. As of end-August, many of these stocks had registered massive year-to-date (YTD) gains – Apple was up 76%, Microsoft 43%, Amazon 87%, Alphabet (Google’s holding company) up 22% and Facebook 43% – well ahead of the index which was up 8.3%. Given their size and the scale of their gains, these companies have dominated S&P500 performance this year. In fact, the equallyweighted version of the index – where the smallest stock counts for as much as Apple – was actually down 4% YTD at end-August. This means that the breadth of the market – that is, the proportion of stocks which are contributing to index gains – has deteriorated sharply this year, often a warning sign for investors.
Moreover, price gains have outstripped earnings forecasts by a substantial margin – for example, earnings-per-share (EPS) estimates for Apple’s current financial year are up by only 9% compared to 2019. This means that the bulk of this year’s performance has come through multiple expansion – the mega-caps (and hence the market as a whole) have simply become ever more expensive. As a result, US equities currently trade at 27 times this year’s EPS, a 64% premium to the median valuation over the last decade.
The month of August saw a sharp move higher for the S&P500, up another 7% during what is normally one of the quietest periods for equity trading. Normally, when equity markets are moving higher, risk aversion tends to decline. One of the tools used to gauge risk appetite is the implied volatility of options on the S&P500, as measured by the VIX index – when this index moves lower, this suggests investors are becoming more complacent and adventurous. This August however, the VIX rose as prices advanced – a most unusual state of affairs. Part of the explanation for this apparent contradiction may lie in some unusual trading patterns in options on individual stocks, in particular “call” options which give holders the right to buy a stock at an agreed price and by a fixed date. The proportion of options to sell stocks (known as “puts”) compared to calls reached multiyear lows in August as traders used options to leverage their exposure to tech stocks. Part of the buying was carried out by Japanese conglomerate SoftBank (dubbed the “Nasdaq whale”), which spent $4bn on calls recently, but this was dwarfed by a shoal of retail investors who spent almost $40bn on calls in the last four weeks – the average 4-week total paid for calls had never been above $10bn until this year. Given such heavy volume, investment banks which issued the calls have been forced to hedge their risks by purchasing the underlying stocks, thereby adding to the buying pressure.
Bottom line. The quality and strength of the mega-cap tech and internet stocks has justified their rise to pre-eminence in the market. However, this has come at the price of heavy index concentration, speculative flows and skyrocketing valuations. These factors have led us to diversify portfolios into other assets, markets and sectors to maintain balance, as outlined in our Q3 House Views. This month’s sell-off in tech only reinforces that conviction.