“Clear” below the calm surface of the bull market
“Annihilate” is an apt description of what is going on beneath the calm surface of the bull market.
As we approach the end of the year, many are hoping “Santa Claus to visit Broad and Wall.” However, those hopes are not just about adding to this year’s already excessive annual gains. Instead, for many, it is the hope of recovering from brutal losses.
If you haven’t paid it much attention, the market is currently near its all-time highs. While it has increased by almost 26% this year, there have been a few very normal 5% fixes along the way.
Looking at the chart, you would assume that the performance across the entire index was roughly even. However, that would be a wrong assumption.
As the old saying goes:
“You can’t judge a book by its cover.”
Market capitalization weighted illusion
One of the problems in financial markets today is the illusion of performance. This illusion is created by the largest stocks weighted by market capitalization. (Market capitalization is calculated by multiplying a company’s price by its number of outstanding shares.)
In particular, with the exception of, the main stock market indices are weighted by market capitalization. Therefore, as a company’s stock price appreciates, it becomes a more important component of the index. This means that the most important changes in the price of stocks have a disproportionate influence on the index.
You will recognize the names of the top 10 stocks in the index.
Currently, the top 10 stocks in the index represent more than a third of the entire index. In other words, a 1% gain in the top 10 stocks equals a 1% gain in the bottom 90%.
Another look at contribution asymmetry is to compare the number of companies it would take to understand the same weighting. Currently, out of 500 stocks, the lowest 432 stocks have the same market cap as the top 10.
This is the story of 2021. Without the huge returns from companies like Apple (NASDAQ :), Google (NASDAQ :), Microsoft (NASDAQ :), Tesla (NASDAQ 🙂 and NVIDIA (NASDAQ :), the years of return would be very different.
Below the surface, the damage is evident
As noted, without the backing of the Top 10 stocks, year-to-date returns and overall volatility would be quite different.
However, by examining a sample of the most “popular” trading stocks, you can understand the frustration of current retail traders. A large majority of high-profile stocks in 2020 and early 2021 are down significantly from their respective 52-week highs.
Of course, probably one of the best representations of the disparity between the index and the “to wipe–outside” Below the surface is the ARKK Innovation Fund (ARKK). In 2020, the media named Cathie Wood the best investor of the year. Millennials and Gen Z investors put money into his fund to chase upcoming next-gen tech stocks.
Unfortunately, that turned out to be a bad bet.
While the index is up around 25% in 2021, ARK Innovation ETF (NYSE 🙂 is down over 20%. It’s quite a performance differential, but it shows the disparity between mega-cap companies and everyone else.
However, it is NOT just the “even” stocks that significantly underperformed the index. If you had a diversified portfolio of small, medium, emerging and international stocks, the performance would be significantly lower than the S&P 500 Index. This is something we discussed in the
Globally, as noted Merchant of feelings, pretty much everything underperforms the S&P 500.
“The percentage of country ETFs outperforming the S&P 500 year-on-year has fallen to its lowest level since May 2020.”
As they conclude “
The strength is mainly evident in the United States, with foreign indexes showing an alarming level of relative underperformance. When trends have lagged like this in the past, the annualized returns of the MSCI indices have been mediocre.
A significant risk
The point to take away from this analysis is the significant risk posed to investors whose capital is hidden in a handful of stocks. Over the past few weeks, we have noted the in the markets, as well as a low breadth. To witness it:
The stock market is a function of buyers and sellers accepting a transaction at a specific price. Or rather, “for every seller there must be a buyer.”
This is why market declines tend to be a “annihilate” Rather than a “Recoil.”A good example recently was DocuSign (NASDAQ :).
When there are not enough buyers at current prices to absorb increased selling pressure, prices increase. While there are indeed buyers for every seller, they are priced significantly lower.
However, during these “Erasures”, capital continues to flow into the main holdings of the index. This is because these stocks are very liquid. For traders, they offer a “Safe haven” move large amounts of capital without creating a gap between buyers and sellers.
However, if capital flows reverse from these top 10 stocks for any reason, the illusion of a strong market will quickly fade. Most likely, these flows will be invested in bonds for the sake of safety, as something has likely changed the bullish psychology of the market.
Just in case you’re wondering, buyers are much lower at Apple right now.
While the top 10 holdings of the major indices continue to be a “Safe haven” for traders now, by 2022, i would be watching them closely. They will probably be the best indication of when the flight to safety has started.
Of course, if you held “even” stocks this year, the “annihilate” should already make you think about changing your investment strategy.