Good morning. As my mother used to say: if you owe me $100, that’s your problem. If you owe me $4.7bn, that’s my problem. She worked at a bank. Send us your examples of homespun financial wisdom: robert.armstrong@ft.com & ethan.wu@ft.com.
The average stock versus the index
For most of the last year, the stock market has followed the Big Tech companies. This makes a certain amount of sense. Apple, Microsoft, Amazon, Alphabet and Tesla make up 20 per cent of the S&P 500. If they are doing badly, a lot of other things have to do well to keep the market rising.
One way to think about the relationship between the great Big Tech stocks and the broader market is by comparing the equal weight S&P index — where the performance of every stock counts the same — to the plain vanilla S&P, which is structurally overweight Big Tech. The relative performance of the equal-weight index is the light blue line in the chart below. What is interesting is that recently, when the equal-weight index has done relatively well, the index itself (the dark blue line) has done very badly. Note that this is not analytically true: in a broad rally, the average stock can do very well, and the index can still rise.
What that chart shows, in short, is the performance of a few huge stocks, mostly the Big Techs, dragging the index around. But in the most recent rally, things have changed meaningfully, as you can see by looking at the extreme right part of the chart. Since the beginning of October, the equal-weight index has outperformed, and the index has risen. The market has rallied without Big Tech.
Another way to look at this is to compare sector performance in the current rally to the last rally, from mid-June to mid-August:
The two rallies are very different indeed. In October and November (light blue lines) the top four performing sectors (energy, industrials, materials, financials) are cyclicals, while consumer discretionary (Amazon and Tesla!) is down 40 per cent. Over the summer, consumer discretionary and tech were among the winners.
I am not sure what to make of this shift. It puzzles me slightly, for example, that cyclicals are doing so well recently, given that the yield curve is signalling recession (see below). But in any case, the temptation to say the current rally is just like the last (failed) one should be resisted. The different sector performance tells us that something very different is going on. The last rally was the market falling back on the Big Tech leadership it had leaned on for years. This time, the average stock is doing the work.
Chris Verrone of Strategas compares the current period to 2000-2002. Then, most stocks in the index rallied, but the index as a whole struggled, dragged down by heavy weighting to former “dotcom darlings” such as Cisco. If that story is repeating itself, that’s bad news for the index and for Big Tech, but I am a bit sceptical. Big Tech was never as overvalued this time around.
Spreads and the yield curve
The yield curve is really, really inverted, which really, really predicts a recession. Here is a long-term chart of the 10-year/3-month curve (which is less noisy than the more popular 10-year/2-year curve):
All four of the other times this curve broke below the zero line, a recession followed in short order. This is not voodoo. When the Fed has dragged short-term rates above long-term rates, that constricts the economy. That’s how monetary policy works.
So a recession seems like a pretty strong possibility, and other factors (slowdowns in Europe and China, manufacturing activity falling off, lower liquidity in the financial system) back up the yield curve on this.
What is slightly weird is that some measures of inverter risk appetite seem to disagree. Take, for example, triple-C bonds’ yield spread over Treasuries. These are the junkiest junk bonds. In the spring and summer, when the yield curve narrowed ominously, CCC spreads stuck to the script, and rose; higher chance of recession, higher default risk, fine. But in the last six weeks or so, as the yield curve has plunged below zero, spreads have shrugged:
I can think of three basic explanations for this:
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The yield curve is wrong about recession. The pandemic and the extraordinary policy responses to it are one-off events, and we can have a tightening cycle with only a mild slowdown this time.
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The yield curve is right about recession, but this will be a low-default recession. This is, unsurprisingly, many junk bond managers’ view. When rates approached zero in 2020, even the junkiest companies were able to refinance and term out their debt, and most of them did. Most of them will muddle through a downturn just fine.
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Bond yields are living in a dream world, and will rise soon.
Ed Al-Hussainy of Columbia Threadneedle as usual provided me with a more sophisticated take than I could have come up with myself. Spreads reflect both default risk and expected rate volatility, and as we get closer to the end of the tightening cycle, rate volatility is starting to come down, allowing spreads to remain stable.
I’m inclined to favour a combination of #3 and Ed’s view, but, in any case, watch this relationship. It’s going to matter.
One good read
Amen to this: let crypto burn.
