Unlikely Match: Big Tech Takes on Small Markets in a Surprising Showdown – You Won’t Believe the Outcome!

Good morning. Job openings in the US increased in April. Despite the fact that no one particularly trusts this data series, was widely discussed yesterday as a further sign that the job market remains tight and there could be another rate hike in our future. Booooo. All eyes are now on Friday’s jobs report. Well, not quite all eyes. Mine are on tech stocks. Send me an email: robert.armstrong@ft.com.

Technology, alone

Here’s a chart of the relative performance of the six superstar tech stocks (Apple, Amazon, Google, Meta, Microsoft, Nvidia) against the S&P 500 with those six names removed:

The recent staggering outperformance of megatechs closely resembles the run-up they enjoyed during the first pandemic days of 2020. But this time things are different. For most of the latest tech mega rally, the rest of the index was up as well, but not as fast. This time, the mega-technicians put their index fingers on their shoulders. Here is the performance of the S&P 500 minus the super six:

Tight markets are believed to bode badly. We had a fight the past that narrowness is a noisy signal that, in itself, doesn’t bother us all that much. But, as with most stock market indicators, there are as many views as there are ways to slice the data.

Our view that narrowness wasn’t too big a deal was based on a measurement of breadth that looked at how many stocks were making new highs versus those making new lows. LPL financial’s Adam Turnquist, in contrast, defines breadth by the proportion of S&P 500 stocks above their 200-day moving average. He finds a strong correlation between tight markets and weak index performance over the next year. He divides the market into quartiles based on breadth, using data going back to 1991. We are now in the fifth, or narrowest, market quartile:

Don’t panic yet. BMO’s Brian Belski looks at the past periods in which the top five stocks in the S&P 500 have peaked relative performance (one standard deviation above normal) and found that subsequent returns were okay over the next six and 12 months. He also looked at historical periods, dating back to 1990, in which the number of stocks that outperformed the index fell sharply, and found that over the next 12 months, the S&P 500’s returns were average.

Given that different ways of defining breadth lead to different results, one can’t help but suspect that there is an element of data torture here until they confess. Unhedged continues to suspect that breadth by itself is not a reliable indicator. It must be accompanied by an account of Why the market is tight, and that account must also help explain why there should be a future market decline.

The 2020 Big Tech rally corresponded with rapidly falling interest rates. The outperformance has thus been widely attributed to “long duration”: Because much of growth stocks’ cash flows are far in the future, a lower discount rate increases their value disproportionately, it said. We never really liked this explanation, but in any case it doesn’t hold water now. Big Tech jumped in 2023 amid roughly sideways movement in long-term bond yields. So what’s driving the super six now? There are two explanations, one reassuring and one worrying.

The first explanation, which Unhedged has leaned in the past, is that Big Tech stock’s strong free cash flow, high barriers to entry, and central location in the modern economy make them sensible things to own when the world is starting to falter. Despite moments of doubtwe still believe it (although the run-up to the super six valuation makes us believe a little less; Apple’s price/earnings ratio, for example, has gone from 20 to 29 this year).

The second explanation is that the super six are arising on a narrative. The narrative, put simply, is that AI will be a bigger deal than the internet, PC, printing press, wheel and fire combined, and that mega-technologies are best placed to take advantage of it . I don’t know anything about AI, but I have some experience with market narratives. They are not strictly tied to facts and do not last forever.

Corporate bodies and share performance

There is a large amount of literature on the influence of management skills on stock performance. Most, in my experience, are unsatisfactory. Because executive excellence is difficult to measure directly, most studies treat it as a residual. In other words, for a given company over a given period, any measurable factor that could explain the stock’s performance (market returns, industry performance, etc.) is eliminated and all that remains is attributed to good leadership.

However, the influence of a good board can be measured a little differently. Because smart directors are in demand, good ones tend to serve on multiple boards of directors or as executives of other companies. You can compare companies whose board members have many connections to other companies with companies with less well-connected boards and see if the former perform better. Several studies (see e.g Here AND Here) have found that they do.

Wolfe Research’s Yin Luo took another look at this idea in a recent report, and her findings are interesting. Look at companies where the board has strong ties to highly successful companies, as measured by a range of financial measures, but where the company itself scores poorly on those measures. The argument is that the board should be able to use its connections and experience to improve late performance.

Looking across a vast universe of companies, Luo discovers that the argument is valid. Having connections to strong companies on the board predicts improved performance in areas such as earnings growth, margins and valuation.

One particularly interesting result: Companies with strong ties to the boards of companies with, for example, high returns on equity, but which did not themselves have a high ROE, had significantly lower downside risk than those with ROE high. The average maximum inventory draw for well-connected companies is in green below; that of companies with a high ROE in red. Luo breaks down the results by period:

This is what a good board of directors is supposed to do, after all: keep a company from falling into serious trouble.

I wondered, reading the study, about the direction of causality. Do good administrators improve business performance or are they looking for promising companies to serve? I asked Luo the question, and he thinks it’s probably one of two things. I take the latter view myself, on the grounds that it’s easier to recognize potential than it is to fix companies without it. This makes a connected card a signal much like preferred stock purchases. For investors, of course, the direction of causality doesn’t matter: the point is that connected directors could be a useful buy signal, especially for underperforming companies.

A good read

Economic liberals and Brexit.