An extremely narrow advance

The global rally lacks breadth, with only a few tech stocks driving the surge. In contrast, India's market stands out as an exception

Coming into 2023, there was almost universal bearishness on global markets, especially the US. It was the first time in this century that the consensus of Wall Street Strategists had actually forecast a market decline. The sell side is almost always bullish, so for them to forecast a market decline is rare indeed. It just shows the extent of bearishness that prevailed at that time. The bearish case was clear, inflation was still not in control, the Fed was in the midst of its most aggressive rate increase campaign in years, a recession seemed imminent and the risks of a financial accident were clear. Markets were coming off a very difficult 2022, where both equities and bonds declined by double digits and were seen as still being expensive.

However, the markets, especially in the US, have surprised positively. The S&P 500 is up about 13 per cent for the year. One of its best starts to a year in decades. Most investors have been left behind, with their caution detracting from performance. Despite the regional banking crisis in the US, the collapse of Credit Suisse, and the beginnings of stress in the commercial real estate markets, equities have powered through.

It has, however, been a very difficult market for investors as the breadth has been horrendous. If you were not smart enough to be involved in the artificial intelligence (AI) beneficiaries of big tech, you had no chance of keeping up with the markets. Just for context, here are the facts: In this 13 per cent rise of the S&P 500 year-to-date, 90 per cent of this increase has been accounted for by just 10 large capitalisation tech companies (counting Tesla as a technology company). NVIDIA has led the pack, rising by almost 165 per cent, becoming the first semiconductor company to ever cross the $1 trillion mark in market capitalisation. It is a clear and obvious beneficiary of the surge in interest in AI, as its graphics processing units (GPUs) power most AI models and their training and inference. Meta has the next best performance, up approximately 120 per cent, followed by Tesla and AMD at around 90 per cent. The tech titans (Apple, Microsoft, Google and Amazon) are up between 40 and 45 per cent. The two remaining winners are Broadcom and Salesforce.

Even if you broaden your universe to the top 1,500 stocks in the US, as Bernstein has done, you find that these same 10 stocks account for over 75 per cent of the total performance of 12.5 per cent delivered by the top 1,500 stocks.

This lack of breadth is unusual and worrying. Bernstein went back and looked at data for more than 40 years, and never before in any six-month period have only 10 stocks delivered an absolute return of 9.4 per cent. Both the narrowness of the advance and the quantum of absolute returns delivered by the 10 stocks are highly unusual. It shows that the tech giants with large index weights have delivered large positive returns. The periods that come close to the last six months are the second half of 2020 and second half of 1999, the blow-off phase of both those technology peaks/bubbles when the top 10 stocks delivered about 6.9 per cent absolute performance.

Beyond the concentrated nature of the market move, what is also surprising is that the 50 per cent average return of the top 10 stocks has been delivered almost entirely by multiple expansions. Beyond the earnings upgrades for NVIDIA, as a basket, there are no earnings upgrades for the balance nine stocks. The AI craze has driven the multiples up. These 10 companies are seen as being in the best position to leverage AI, given their scale, cash flows, access to data and intellectual property. In prior periods of concentrated returns, the top 10 have delivered their strong performance through a combination of earnings upgrades and multiple expansion. Unlike today, earnings upgrades have been a key factor in driving the excess returns historically.

As investors, we always worry when markets lack breadth. The rise is seen as unhealthy and unsustainable. If accompanied with declining volumes, it is seen as even more problematic. Bernstein has looked at historical data to try and understand how markets and individual stocks perform after a sustained lack of breadth.

Their data shows that following periods of very concentrated market advances in the US, in the next 12 months markets do tend to underperform, but only mildly, by about 70 basis points. This is counterintuitive, as one would have thought that the performance drag would be much higher. The stocks that have delivered the concentrated returns, however, tend to do worse. They underperform by about 380 basis points in the 12 months after a period of very concentrated market returns. Going by this data, we should soon see a period of underperformance ahead for the 10 tech stocks leading this rally. Given the 50 per cent price appreciation these stocks have delivered to date, a period of consolidation, with the rest of the market catching up, is only to be expected. The bigger question is what happens after this inevitable consolidation. Will big-cap tech resume the outperformance, or will the AI hype settle down? Will monetisation of AI be visible or will all the gains and productivity be competed away?

This has been a really tough market for investors to navigate. If you have not been invested in the 10 mega cap tech names, you are probably at best flat for the year. Career risk will inevitably force investors to herd into these stocks, just when their period of maximum outperformance is over. China, the darling of the value investor crowd, remains a very tough place to be, especially if you are still wedded to the winners of the past (China internet ) which look genuinely cheap today.

India, on the other hand, is at the other extreme, with incredibly good breadth and a well-spread advance. While the Indian markets remain expensive and the flood of paper is a worry, it does not have a breadth problem. It is approaching a new high with very good breadth and participation.

After the collapse of the unprofitable technology names and the funding nuclear winter among the venture capital ecosystem, we thought that we could look forward to a period of normal markets with limited sectoral and thematic excesses. The record adoption and interest in AI, following the unveiling of ChatGPT, has led to the building up of a new hype cycle. How far it goes and for how long is anyone’s guess. We, as investors, have to understand this new animal and its implications for specific stocks and sectors. Will AI be a net benefit or drag for Indian technology companies? That is a moot question. No one seems to have a good answer. Many man-hours will need to be devoted to try and understand this dynamic.

The writer is with Amansa Capital