Market see-saws always have two ends

The writer is chief executive and chief investment officer of Richard Bernstein Advisors

Experiencing the ups and downs of a see-saw is a fun part of many childhoods. But sitting on the fulcrum of a see-saw is no fun, since it doesn’t move relative to the levered ride at both ends.

The equity market over the past several years has acted like a see-saw, with “the market” representing the fulcrum of that see-saw. Overall market statistics mask the significant performance disparities at the seesaw’s ends.

Technology, cryptocurrencies, innovation, disruption, artificial intelligence and other attention-grabbing investments sit on one side of the see-saw, whereas everything else in the global equity markets sits on the other side.

Market rotations over the past several years have mimicked our see-saw portrayal. In 2020, the exciting side of the see-saw rose. Technology, consumer discretionary and communications were the three top-performing sectors. Cryptocurrency returns were measured in hundreds of per cent, and seven large technology-related companies (now dubbed the Magnificent 7) more than doubled.

The see-saw began to level in 2021 and the everything else in the world side rose in 2022. Seventy per cent of non-US markets outperformed the US in US dollar terms during 2022. The broad-based US market index Russell 2000 outperformed the Nasdaq-100 by 12 percentage points and outperformed the Magnificent 7 by a decisive 25 percentage points.

The see-saw has dramatically shifted back in the other direction so far in 2023. Bitcoin, despite its recent pullback, is up more than 50 per cent. Communications, technology and consumer discretionary are again the best-performing sectors by wide margins. 

Most importantly, the number of stocks sitting on the rising side of the see-saw has shrunk dramatically. The Magnificent 7 are up 95 per cent this year to August 31 and just those seven companies contributed a whopping 71 per cent of the S&P 500’s rise in 2023.

Research I worked on with colleagues at Merrill Lynch in the early 1990s showed that financial markets become “Darwinistic” and leadership narrows when profit cycles decelerate. Survival of the fittest describes the environment as investors gravitate to the fewer and fewer companies that can continue to grow their earnings. 

However, markets broaden when the profit cycles accelerate because lower-quality and more cyclical companies have greater operating and financial leverage. Using the hackneyed analogy, a rising tide lifts all boats.

According to that framework, the Magnificent 7’s unique outperformance during 2023 implicitly incorporates an extraordinarily dire forecast of corporate profits, the global economy, and even overall corporate survival in which only seven companies will grow. There clearly are many more than seven growth stories in the entire global stock market, so there may be many ignored opportunities on the other side of the see-saw.

US small caps, Europe, Japan, China and US themes focusing on real productive assets and the rebuilding of America’s manufacturing capacity all seem particularly attractive. 

Artificial intelligence is not included in the list of attractive investment themes. AI will undoubtedly change the economy as new technologies always do. However, investors have to dispassionately separate hype from an investment opportunity. The internet meaningfully changed the global economy, but if one had bought Nasdaq a full year before the tech bubble peaked, it would have taken 11 years just to break even. Because they already sit on the exciting side of the see-saw, AI investments are likely to similarly disappoint investors.

Individual investors appear to have become risk-takers as they rode upward on the see-saw. Take a look at the “beta” of their portfolios — a measure of how volatile their positions are relative to the market. A beta below one indicates less volatile holdings and a reading above one more volatile.

According to Bank of America’s strategy team, the typical equity beta within private client portfolios in 2009 was about 0.75 and the equity allocation was 39 per cent. Today, the beta is 1.20 and allocation is 60 per cent. Total equity exposure (allocation times beta) suggests individual investors are confident and show few signs of the fearfulness they consistently demonstrated in the early years of the bull market.

Individual investors are enthusiastically riding the see-saw upward, but their increased risk-taking suggests they’ve forgotten see-saws have two ends. The better and wide-ranging investment opportunities may be on the side of the see-saw closer to the ground.