The Top Ten Stocks

Passive ETFs are hiding a bear market in stocks. That may sound like a strange statement when you look at major stock market indexes hovering near all-time highs. However, much like an iceberg, what we see on the surface hides much of what lies beneath.

One of the problems with the financial markets currently is the illusion of performance. That illusion gets created by the largest market capitalization-weighted stocks. (Market capitalization is calculated by taking the price of a company multiplied by its number of shares outstanding.)

Notably, except for the Dow Jones Industrial Average, the major market indexes are weighted by market capitalization. Therefore, as a company’s stock price appreciates, it becomes a more significant index constituent. Such means that prices changes in the largest stocks have an outsized influence on the index.

You will recognize the names of the top-10 stocks in the index.

Currently, the top-10 stocks in the S&P 500 index comprise more than 1/3rd of the entire index. In other words, a 1% gain in the top-10 stocks is the same as a 1% gain in the bottom 90%.

Such is the story of 2021. Had it not been for the enormous returns in companies like Apple (AAPL), Google (GOOG), Microsoft (MSFT), Tesla (TSLA), and Nvidia (NVDA), the return for the year would be much different.

The same story holds for the Nasdaq, which is also heavily dominated by the same stocks as the S&P 500. As noted, without the support of the top-10 holdings, the year-to-date returns and overall volatility would be very different.

If we look at a sampling of the more “popular” trading stocks, you can understand current retail traders’ frustration. A vast majority of 2020 and early 2021’s high-flying stocks are down significantly from their respective 52-week highs.

Of course, probably one of the best representations of the disparity between what you see “above” and “below” the surface is the ARKK Innovation Fund (ARKK). While the S&P 500 index was up roughly 27% in 2021, ARKK is down more than 20%. That is quite a performance differential but shows the disparity between the mega-cap companies and everyone else.

After Wednesday’s post-FOMC selloff, more than 38% of stocks trading on the Nasdaq are now down 50% from their 52-week highs. Only 13% of days since 1999 have seen more stocks cut in half.

At no other point since at least 1999 have so many stocks been cut in half while the Nasdaq Composite index was so close to its peak. When at least 35% of stocks are down by half, the Composite has been down by an average of 47%.

The last sentence is critical. There is no precedent for when so many stocks were in a bear market, yet the index was near its historical highs.

So, how is it that despite the destruction below the surface, so many indexes hold near highs? Not surprisingly, it is a mirage caused by passive indexing.

Currently, more than 1750 ETFs are trading in the U.S., with each of those ETFs owning many of the same underlying companies. For example, how many passive ETFs own the same stocks comprising the top-10 companies in the S&P 500? According to ETF.com:

363 own Apple
532 own Microsoft
322 own Google (GOOG)
213 own Google (GOOGL)
424 own Amazon
330 own Netflix
445 own Nvidia
339 own Tesla
271 own Bershire Hathaway
350 own JPM

In other words, out of roughly 1750 ETF’s, the top-10 stocks in the index comprise approximately 25% of all issued ETFs. Such makes sense, given that for an ETF issuer to “sell” you a product, they need good performance. Moreover, in a late-stage market cycle driven by momentum, it is not uncommon to find the same “best performing” stocks proliferating many ETFs.

Therefore, as investors buy shares of a passive ETF, the shares of all the underlying companies must get purchased. Given the massive inflows into ETFs over the last year and subsequent inflows into the top-10 stocks, the mirage of market stability is not surprising.

Despite the best intentions, individual investors are NOT passive even though they invest in “passive” vehicles. Eventually, some exogenous, unexpected event will change investors’ “speculative” psychology. When the psychology changes from “bullish” to “bearish,” the rush to liquidate entire baskets of stocks will accelerate the decline making sell-offs more violent than what we saw in the past.

This concentration of risk, lack of liquidity, and a market increasingly driven by “robot trading algorithms,” reversals are no longer a slow and methodical process but rather a stampede with little regard to price, valuation, or fundamental measures as the exit becomes very narrow.

March 2020 was just a “sampling” of what will happen to the markets when the next bear market begins.

Consumer Sentiment

U.S. consumer sentiment soured in early January, falling to the second-lowest level in a decade as Americans fretted about soaring inflation and doubted the ability of government economic policies to fix it, a survey showed on Friday.

The University of Michigan said its preliminary consumer sentiment index fell to 68.8 in the first half of this month from a final reading of 70.6 in December. Lower-income households held a more negative outlook than wealthier ones, with sentiment dropping by 9.4% among households with total incomes below $100,000, but rising by 5.7% among households above that threshold.

Economists polled by Reuters had forecast the index would decline but only to 70.0. The sharper-than-expected drop in sentiment comes as Americans face various headwinds despite an overall strong economy, with inflation topping the list of concerns amid a record level of COVID-19 cases due to the Omicron variant that could in turn prolong high prices.

US Economy

The December payrolls increase surprised to the downside again.
At the same time, the unemployment rate dipped below 4% for the first time in this cycle. The divergence points to further tightening in the labor market.
The overall labor force participation rate held steady.
The breadth of job gains across industries deteriorated.
The headline unemployment rate is now firmly below the natural rate of unemployment.
Used vehicle prices continue to surge.

US consumers are tapping their credit cards again.

Student debt growth continues to slow.

The probability of a full 100 bps Fed rate increase this year is nearing 90%, according to the futures market.
COVID cases continue to climb, with some five million Americans now forced to stay at home due to exposure.

Hospitalizations may also hit a new high.

For the first time in decades US and China economies might grow at a similar rate.
December winners and losers:

Goldman expects the Fed to hike rates four times this year, which is consistent with the market (the futures-based probability is now above 90%). But beyond this year, Goldman sees a more aggressive rate hike trajectory than the market.
Mortgage rates continue to climb. Currently at 3.6%
The recent supply chain bottlenecks have been delaying residential construction projects.
Apartment occupancy rates have been surging.
The NFIB small business sentiment index ticked higher in December.
Businesses are increasingly worried about inflation and the cost of labor.
Businesses continue to face challenges attracting workers.
The Evercore ISI Retailers index showed softer sales activity at the start of the year.
Some 1.7 million Americans were not at work due to illness in December.
As expected, the CPI +7% hit a four-decade high in December, driven by supply bottlenecks and robust consumer demand for goods.
Here are the key components.

An important driver of rapid price gains has been the massive demand for goods, as Americans put their excess savings to work.
Durable goods have unwound two decades of deflation.

Here is the CPI “heat map.”

Economists see inflation peaking within a month or two but staying elevated for some time.
The Fed’s Beige Book shows companies still worried about climbing costs and supply chain issues. And the pandemic is back in focus.
What factors are driving businesses to boost prices?

Here are the Fed rate hikes that are fully priced into the market (note that there is a high probability of these events occurring sooner).

Lumber prices continue to climb. Here is the March contract.

Food away from home:

Furniture:

The Fed

Let’s set the scene…

Inflation is running at multidecade highs, the unemployment rate is near multidecade lows, and a $9 trillion balance sheet is still on the central bank’s digital books. To top it off, the current Fed chair is being nominated for another term.

Here are the big takeaways from his answers to his Senate confirmation hearings…

In Powell’s view, the pandemic has been the largest, most direct cause of inflation. The Fed assumed that once vaccines rolled out, supply-chain bottlenecks would ease, and supply and demand would rebalance relatively quickly, but we’re still waiting for that to happen. “Getting past the pandemic is the single most important thing we can do,” Powell said.
Powell said this year is the time to end super “easy money” policies. “Right now, we’re stimulating demand with highly accommodative policy,” he said, like near zero lending rates and ongoing bond-buying operations. “The economy no longer needs or wants highly accommodative policies.” Over the course of 2022 he said policy will return “closer to normal, but it’s a long road to normal.”
The Fed’s rollback of said highly accommodative policy looks like this for now: End its asset purchases ($60 billion in bonds and mortgage-backed securities a month) in March, raise its benchmark interest rates throughout the year, and then start to thin its huge balance sheet, possibly later this year, settling in at a to-be-determined rate.
This a big one: In the meantime, inflation is going to continue. A couple small rate hikes aren’t likely to tame it. “Real” rates – yields minus inflation – will still be negative. “We’re going to learn a lot about the path of inflation through the first six months of the year,” Powell said. Does he expect inflation to subside? “Over time, yes,” he said. “The question is how fast.”
On a related point, Powell admitted that he and the other Fed members misjudged the scope of inflation that we saw coming over the last 12 months. “We and all other mainstream forecasters forecasted by now we’d be seeing much lower inflation.” This is where we remind you that “price stability” is one of the Fed’s two mandates. Surely, they could have envisioned this scenario, like so many others did. Remember this the next time a crisis hits.
In the job market, some wages are increasing, the unemployment rate (of those in the workforce) is low, but labor participation is still lower than pre-pandemic, meaning the people who left work amid the pandemic haven’t been replaced on balance. Powell said a long economic “expansion” will likely be needed for workforce participation to reach prior levels.

The long and the short of it is that the Fed is saying it wants to slowly take stimulus out of the economy, thus the “it’s a long road to normal” line.

You could argue pre-pandemic “normal” is long gone and never coming back. But even if it does get somewhere close to normal, high inflation could stick around for at least a few more months, especially in the Fed’s slow-moving, backward-looking economic data world. Prepare accordingly, people.

Here is a wide-ranging interview with Gavekal’s Louis Gave, with his 2022 outlook for Fed policy, bonds, gold, commodities and stocks. He shows how it all ties together in one big picture.

Key Points:

Financial markets haven’t responded to high inflation because investors expect significant monetary and fiscal tightening.
Gave does not believe this will happen. He thinks the Fed actually wants inflation as a way to rationalize debt.
The Fed may try to raise rates but will back off quickly as equity markets crack.
More likely, inflation will drop to around 4%, letting the Fed “delay” further tightening.
Today’s concentrated stock market is comparable to the 1970s Nifty Fifty, but this time it’s the Nifty Ten.
China is the only major economy with positive real yields, and is outperforming because it can attract capital.
Beijing’s priority has shifted from job creation to de-dollarization.
Commodity markets are strong due to lack of supply, not rising demand.

Bottom Line: Louis Gave compares today’s environment to the post-WW2 era when 15 years of negative real rates helped work off massive wartime debts. If that’s what the Fed is doing, maybe the Great Reset is already underway.

Market Data

Treasury yields keep rising, with the 10yr hitting a cycle high

pushing up mortgage rates.

The S&P 500 is holding support at the 50-day moving average.

The Nasdaq 100 is also at support.

The Nasdaq Composite breadth has been deteriorating.
After last week’s sell-off, more than 38% of Nasdaq stocks were down 50% from their 52-week highs.