The S&P 500 is still near record levels, but almost 80% of the stocks that make up the index declined in September. The fact that a small number of large companies in the technology and AI sectors are causing Wall Street to appear much healthier than the typical stock really is.
An unusual situation is taking place in the American stock market. In September the S&P 500 hardly changed, dropping by about half a percent, even so nearly 80% of the companies in the index saw their values fall. The average price of an S&P 500 stock decreased by approximately 5%, and only two of the 11 sectors making up the index ended the month up. At the same time, the Nasdaq, which is made up mainly of technology companies, stayed comparatively stable since investors kept on rewarding those companies linked with artificial intelligence and spending on data centres. The Wall Street Journal
Friday arrived, and weak September employment figures revealed that the United States had gained only 29,000 jobs, which in turn caused the S&P 500 to rise by 0.73 per cent, the Nasdaq to go up by 1.19 per cent and the Dow to increase by 0.49 per cent as investors cut their expectations of another Federal Reserve rate hike in October. The S&P 500 ended the day at 7,722.72, maintaining the headline index remarkably near its highs. However, the gain on Friday does not cancel out what had taken place beneath the market during September. It does instead underline the odd situation that investors are now facing: the index may appear to be in good shape even though the majority of its individual stocks are performing poorly. Reuters
The reason is hidden in the method used to construct the S&P 500.
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The companies included in the S&P 500 do not all have the same level of influence. Instead, the index is mainly based on market capitalization, so a company with a market value of one trillion dollars can affect the index much more than a business that is worth twenty billion dollars, even though both of these companies are part of the S&P 500.
That difference has become huge. S&P Dow Jones Indices stated that the 10 largest companies made up 37.8% of the whole S&P 500 by August 31; Nvidia alone accounted for 8.1%. The top group consisted of Nvidia, Apple, Microsoft, Amazon, Alphabet, Broadcom, Meta, Micron and Tesla. In mid-September Citadel Securities estimated that the 10 largest companies had increased their share to about 40% of the index.
This results in a rather odd mathematical situation. It is possible for hundreds of smaller companies to be falling at one and the same time, yet if a large company such as Nvidia, Meta, Alphabet, Microsoft or another huge one rises by a sufficient amount, its market value can compensate for the losses suffered by dozens of smaller firms. September provided an extreme example of this. The top 50 companies rose by about 2 per cent whilst the Russell 2000 index of smaller companies dropped by around 5 per cent. Of the 100 largest companies in the S&P 500, 41 increased in value, whereas among the smallest 100 companies in the index only 10 succeeded in rising. Tiger Brokers
The S&P 500 is therefore not providing investors with a false figure; it is correctly carrying out precisely the function for which it was intended. The difficulty arises when investors treat the S&P 500 as if it reflected the experience of the average American public company. Right now, it does not.
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Artificial intelligence seems to be at the heart of the disagreement. The firms which are holding up the market are not merely the biggest companies; a number of them are directly involved in AI infrastructure, semiconductors, cloud computing or the platforms on which investors expect to make money from artificial intelligence. On the other hand, companies outside this ecosystem are having to face something far less interesting: higher borrowing costs, rising energy prices and intense competition for investment capital.
In September the 10-year Treasury yield rose from about 4.7 per cent to 5.3 per cent, presenting yet another difficulty for ordinary companies. Since higher Treasury yields increase the cost of borrowing across the whole economy and also offer investors a more attractive alternative to equity investments, a company which is trying to finance a factory, refinance its debt or expand its operations finds itself in a very different position from a cash-rich technology giant funding an AI data centre. The Wall Street Journal
Arend Kapteyn, who is the chief economist at UBS’s investment bank, offered a striking evaluation of what is taking place outside the AI boom. He stated to The Wall Street Journal that, if you exclude AI technology companies, capital expenditure “is running at zero.” This point is important since business investment is usually one of the ways in which companies generate future growth. Since capital is increasingly being directed towards AI while other companies are retreating, the current concentration in the stock market could eventually turn into an economic concentration as well. Tiger Brokers
That worry is already being reflected in current earnings expectations. Christian Mueller-Glissmann, who heads asset allocation research at Goldman Sachs, stated that “Since the summer the earnings tailwinds have started to moderate.” Although corporate earnings are still strong, investors are becoming more concerned as to whether the future estimates are still rising. If a market dependent on a small number of companies sees those companies eventually underperform, it becomes considerably more vulnerable. Tiger Brokers
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A important counterargument is that narrow market breadth does not necessarily indicate that the S&P 500 is going to collapse. In fact, the present divergence might one day take an opposite turn. Ben Snider, a strategist at Goldman Sachs, recently stated that the present low level of sentiment together with the narrowness of the market indicate the possibility of “broad market upside” and a catch-up by those stocks which have lagged behind should macroeconomic uncertainty decline. Mike Wilson from Morgan Stanley and Jeff Kilburg from KKM Financial have also mentioned that relief from pressure in the bond market, lower oil prices and strong third-quarter earnings could enable the rest of the market to recover. Investing.com
The situation worth looking at is that the rally on Friday after the weak employment figure showed how fast investors can reenter riskier assets when expectations regarding interest rates shift. Should Treasury yields fall, oil prices drop and the Federal Reserve becomes less aggressive, then a number of the businesses which had suffered in September could recover without it being necessary for AI stocks to crash.
The even more disturbing option is the other way around. If yields remain above 5%, financing will still be expensive and the big AI companies will continue to secure a greater-than-proportionate amount of investment, so the gap between the S&P 500 and the average stock will become even wider. Those investors who think that they hold a widely diversified portion of corporate America via a market-capitalization-weighted index might in fact have a much greater exposure than they realize to the financial performance of a number of technology giants.
The fact that this is so doesn’t mean that the S&P 500 is broken; it only means that it’s more important to understand what’s inside it. On Friday the S&P 500 went up once more and the figure on the screen appeared reassuring. The story behind the market beneath it is a great deal more complicated.Since nearly 80% of the stocks are falling while the index doesn’t move very much, the issue is no longer just whether or not the S&P 500 will rise; it is rather how long a small number of huge companies can keep the rest of the market afloat.