Big Tech, narrow market

Good morning. The number of job openings in the US increased in April. Despite the fact that no one particularly trusts this facts series, it was widely discussed yesterday as a further signal that the labor market remains tight and that there may be another rate hike in our future. Boooooo. All eyes are now on Friday’s jobs report. Well, not quite all eyes. Mine are on tech stocks. Email me: robert.armstrong@ft.com.

Tech alone

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

The megatechs’ recent staggering outperformance is much like the run-up they enjoyed during the early pandemic days of 2020. But this time it’s different. During most of the latest megatech rally, the rest of the index rose as well, just not nearly as quickly. This time, the mega-techies carry the index on their backs. Here’s the performance of the S&P 500 minus the super six:

Narrow markets are generally considered a bad omen. We have argued in the past that narrow-mindedness is a noisy signal that in itself should not cause us too much concern. But – as with most stock market indicators – there are as many opinions as ways to narrow down the data.

Our view that narrowness wasn’t such a big deal was based on a measure of breadth that looked at the number of stocks hitting new highs versus the number of stocks hitting new lows. LPL Financial’s Adam Turnquist, on the other hand, defines breadth by the share of S&P 500 stocks above their 200-day moving average. He finds a strong correlation between tight markets and weak index performance in the following year. He divides the market into quartiles based on latitude, using data going back to 1991. We are now in the fifth, or narrowest, quartile of markets:

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

Given that different ways of defining width lead to different results, one can’t help but suspect there’s an element here of torturing the data until they confess. Unhedged continues to suspect that width alone is not a reliable indicator. It must be accompanied by an invoice Why the market is narrow and that account should also help explain why there should be a market downturn in the future.

The Big Tech rally of 2020 has been accompanied by rapidly falling interest rates. The outperformance was therefore widely attributed to “longevity” – because many of growth stocks’ cash flows are far in the future, a lower discount rate disproportionately increases their value, it was said. We never liked this explanation very much, but at least it doesn’t work now. In 2023, Big Tech has made a leap against a background of more or less sideways movements in long bond yields. So what’s driving the super six now? There are two explanations, one reassuring and one disturbing.

The first explanation, which Unhedged has relied on in the past, is that Big Tech stocks’ strong free cash flow, high barriers to entry, and centrality to the modern economy make them sensible things to own when the world starts to slow down. waver. Despite moments of doubtwe still believe this (although the rise in the valuation of the super six makes us believe it a little less; for example, Apple’s price-to-earnings ratio went from 20 to 29 this year).

The second explanation is that the super six rise based on a story. The story, roughly speaking, is that AI is going to be a bigger deal than the Internet, the PC, the printing press, the wheel and fire combined, and that the mega techs are best positioned to take advantage of it. I don’t know anything about AI, but I have some experience with market stories. They are not closely related to the facts and do not last forever.

Company signs and stock performance

There is a large body of literature on the influence of management skills on stock performance. Most of it is unsatisfactory in my experience. 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 of time, remove every measurable factor that could explain stock performance (market returns, industry performance, etc.) and attribute what remains to good leadership.

However, the influence of good governance can be measured in a slightly different way. Because smart directors are in high demand, good directors tend to serve on multiple boards of directors or as executives at other companies. One can compare companies whose board members have a lot of connections with other companies with companies with less connections, and see if the former performs better. Several studies (see e.g here And here) have found that they do.

Yin Luo of Wolfe Research revisited this idea in a recent report, and his results are interesting. He looks at companies where the board has strong ties to companies that are highly successful as measured by a range of financial metrics, but where the company itself scores poorly on those metrics. The proposition is that the board should be able to use its connections and experience to improve underperforming performance.

Luo looks through a large universe of companies and discovers that the thesis is correct. The presence of board connections with strong companies predicts improving performance in areas such as earnings growth, margins and valuation.

A particularly interesting result: companies with strong governance ties to companies with, for example, a high return on equity – but which did not have a high ROE themselves – had significantly lower downside risk than companies with high ROEs. The average maximum stock take-up for the well-connected companies is shown in green below; those of companies with a high ROE in red. Luo breaks down the results by period:

After all, that is what good management is supposed to do: prevent a company from getting into real trouble.

I wondered, in reading the study, about the direction of causality. Do good executives improve business performance – or do they seek out promising companies to serve? I put the question to Luo, and he thinks it’s probably one of the two. I myself favor the latter view, assuming that it is easier to recognize potential than to repair companies without it. That makes a connected board a signal very similar to insider stock purchases. Of course, for investors, the direction of the causality doesn’t matter: the point is that connected executives can be a useful buy signal, especially in underperforming companies.

A good read

Economic liberals and Brexit.