The heaviest market

Good day. Inflation is still out of control in at least one area: executive compensation. financial time reported Yesterday, CEO pay at S&P 500 companies rose 12 percent this year. This worries me less from the point of view of equity than from the point of view of rationality. The relationship between executive ability and business performance is not well understood. Against this, boards pay CEOs extravagantly to create the appearance of leadership excellence. The worry is that CEOs will begin to believe that their brains are as big as their paychecks. Do you know a CEO worth every penny? Email me: robert.armstrong@ft.com

The game of concentration.

The strong performance of the stock market is increasingly concentrated in a few stocks and more and more people are worried about it. In this weekend’s Wall Street Journal, Jack Pitcher noted The disturbing lack of volatility in the S&P 500 hid the fact that its smooth upward march was fueled by just a few names. Quote Steve Sosnick of Interactive Brokers:

“If you’re too heavy-handed, you hide a lot of other problems and can mask what’s going on beneath the surface,” Sosnick said. “Lately, markets have been driven much more by greed than fear. The problem is that the longer it lasts, the more fragile it becomes.”

Pitcher notes that the equal-weighted S&P 500 is down over the past month. But the market-weighted index’s outperformance has been rising steadily since March last year. Not only the equal-weighted ones have lagged, but also the small-cap and non-US indices:

Yo stay I’m not sure how worrying this really is. We’re in a good environment for stocks: the economy is growing well, profits are rising, and inflation appears to be falling again, clearing the way for the central bank to lower interest rates before long. And, putting the last month aside, it’s surely worth keeping in mind that over the last 15 months, while the average stock has significantly underperformed the big tech stocks, it has performed quite well in absolute terms , with a real annualized return of eight or nine percent, above the historical average (more if dividends are included). It may make sense to worry about whether the amazing performance of Nvidia and the rest of Big Tech can continue, but it’s premature to suggest that the rest of the index is unraveling.

Yes, a resurgence in inflation or a slowdown in consumer spending could shake things up. But that would be true even if the market were less concentrated.

Curiously, the concentration argument can be turned around. One could suggest that the high concentration reflects the fact that the average stock is ripe for better results. Jim Paulsen, who writes the Paulsen Perspectives substack, presents this case. He thinks the equal-weighted index hasn’t performed well because the Federal Reserve has kept rates too high. Every American bull market from the middle of the last century (until this one) started after the Federal Reserve started cutting rates, he notes. While big tech stocks haven’t waited for the Fed to give the go-ahead to start rising, the rest of the market has. Therefore, when the Federal Reserve eases, the market should broaden and the rally will continue.

Paulsen notes that historically the relative performance of the equal-weighted index is inversely correlated with the direction of interest rates (although the relationship ebbs and flows a bit). Your graph:

A similar pattern applies to small-cap stocks, dividend payers, and defensive stocks. Paulsen doesn’t speculate on why this should be the case, but small caps tend to be more leveraged and therefore rate sensitive, and defensives and dividend payers are substitutes for underperforming bonds. when bonds offer more yield, particularly real yield.

Paulsen’s argument is intriguing, but it has a piece of cake quality that makes me a little nervous. The fact that the market has rallied strongly despite higher rates for longer shows that this cycle is not like previous ones. Assuming it will start acting like the above after the Fed cuts seems overly optimistic.

More on American exceptionalism

Last week I wrote about how, over the last fifteen years or so, US stocks don’t seem to lose and emerging market stocks don’t seem to win. This sparked two very interesting and very different responses.

Sahil Mahtani of asset manager Ninety One wrote to argue that much of the poor performance of emerging market indices is attributable to changes in the composition of those indices, changes that (if all goes well) will not be repeated. He sent the following chart breaking down the performance of various indices over the 2011-2021 period into changes in revenue, margins, exchange rates, and what he calls “net issuance”:

As the chart shows, emerging market performance was severely affected by net issuance, which is changes in the denominator of the index. Includes the impact of companies entering and exiting the index through IPOs and mergers and acquisitions, buybacks, secondary issuances, and changes in index provider weights.

The key driver for emerging market net issuance, Mahtani says, is changes in China’s indices. The inclusion of US depositary receipts, Chinese “A” shares and MSCI increases China’s overall weighting in its emerging markets index. Mahtani writes:

Stocks entered the index at high valuations and then declined. For example, ADRs entered MSCI China at 27 times earnings in 2015 and then dropped to 12 times earnings in 2022. We also had many expensive IPOs. Both emerged from a particular geopolitical and liquidity environment that is unlikely to be repeated in the future. Recent data suggests that “net emission” is a third of what it was at the peaks of the 2010s…

Simply put, China’s downgrade hurt the emerging market index not only because China downgraded, but because the emerging market index “bought” China at high multiples to begin with.

in its capital wars In the substack, Crossborder Capital’s Michael Howell wrote that my focus on the price/earnings valuation gap between US and emerging market indices was wrong. He believes emerging market stock prices fluctuate based on capital flows, and buying them because they look cheap on a price/earnings basis is a mistake.

Howell points to the fact that the periods in the 1990s and mid-2000s when emerging market stocks outperformed coincided with large cross-border inflows into Asia and emerging Europe:

When analyzing markets from a macro perspective, Howell believes the key is to think of a market’s valuation as a function of three things: how much of investors’ portfolios are allocated to stocks, the level of liquid cash-like assets available for investment, and corporate profitability. Here is your algebraic expression of that idea (P = market price, E = market profits L = liquidity, GDP = gross domestic product):

The numerator on the right-hand side expresses the idea that stock prices are a function of the amount of cash-like things circulating through the system and the proportion of stocks that investors want in their portfolios. As investors try to rebalance away from cash (a futile exercise on a market level, because cash doesn’t disappear when it’s used to buy stocks), prices rise and valuations rise.

I sympathize with this idea, which I have called “hot potato theory”. There is no doubt that the high valuation of American assets has a lot to do with the fact that the United States is an exceptionally accessible haven for global capital. But while capital flows often cause valuation differentials, it also makes sense to me that sometimes valuation differentials have an effect on flows, particularly when those differentials become extreme.

Why do we buy any security? Mainly to get paid. The price/earnings ratio can be thought of as a measure, not entirely different from a bond yield, of what a stock currently pays or could pay. In other words, invest at a P/E ratio and you will get an earnings yield. At some point, if P/Es in one sector or region fall far below those in another, and the divergence is not explained by economic fundamentals, people will move capital to chase those bargains.

This is not an argument that the valuation gap between the emerging world and the United States will close. It is simply an argument that it cannot continue to expand forever.

a good read

The view from Trees.