These companies tend to exhibit the same characteristics: a solid structural growth story with strong balance sheets and elevated cash levels. As a result, market gains have been concentrated to an increasingly small number of companies. As shown in the chart below, the top five companies in the S&P 500 (Facebook, Amazon, Apple, Microsoft and Alphabet – formerly Google) now account for over 22% of total market capitalisation. This represents the highest concentration in over 30 years.  

This concentration, in just a handful of names, is not healthy and points to narrowing market breadth. Market breadth is a term used in technical analysis to gauge the general direction of the market by looking at the total number of constituents in an index and the ratio of advancing to declining stocks.

Despite the worst economic shock since the second world war, the S&P 500 is now just 8% below prior highs. However, beneath the service, the median stock is 19% below its record high. This 11% differential is one such measure of market breadth which, as shown in the chart below, is at its lowest level since late 2000.

Historically, narrow market breadth has been a strong indicator of large market drawdowns. This was the case ahead of the recession in 1990, the dot-com bubble, sub-prime mortgage crisis and eurozone slowdown in 2016.

Narrow market breadth is always resolved in one of two ways. In the examples cited above, the prior ‘winners’ ultimately failed to generate sufficient earnings to justify their lofty valuations, causing them to drop-down to the rest of the pack, resulting in large equity drawdowns.

Alternatively, an improving economic outlook, accompanied by rising investor sentiment, could cause the laggards to catch-up.

In either scenario, the prior ‘winners’ eventually underperform the ‘losers’ on a relative basis. This can be seen in the chart below which shows market breadth is closely correlated to the blue line, which is the same measure of market concentration used in the first chart above, albeit with the axis inverted. That is to say, as market breadth improves, when the pink line moves from the bottom of the range to the top, the blue line also rises, meaning the top 5 stocks within the index are shrinking in size (underperforming) relative to their peers, and vice-versa.

On the far right hand side of the chart, the disparity between these two measures is extreme. Indeed, stretched valuations could last for some time as evidenced by the market breadth drawdowns in the early and late 1990s, each of which lasted several months. However, at some point market breadth will mean revert and the top 5 holdings will underperform the rest of the index. The bigger they are, the harder they fall.

The top five holdings in the S&P 500 are predominantly in the technology and consumer discretionary sectors. They are the same top 5 holdings that appear in the Nasdaq 100. The chart below shows the performance of the Nasdaq 100 equity index relative to the S&P 500 as a ratio. On this metric, technology valuations have not been this extreme since the dot-com bubble, breaching 3 standard deviations of the four year moving average.

The good news is Facebook, Amazon, Apple, Microsoft and Google are good quality cash generative businesses. The same could not be said for the technology sector in the late 1990s. To that extent, valuations are less extreme than this chart might suggest and we are unlikely to see a fall of similar proportions.

History tells us that, at some point, todays winners will become the losers of tomorrow. Extreme examples include General Electric, General Motors and DuPont. However, these are old industry titans whereas plenty of other companies, like Microsoft and Intel, remain key players. The coronavirus plays to the tech sector rule book and has fast tracked the internet-of-things, resulting in increased demand for remote working IT solutions, online education and other e-commerce services. We think these developments are here to stay and as a result technology stocks should continue to do well in the near term.

Technology stocks are also highly correlated to the deflationary theme which, given the extent of the economic slowdown, will remain in place over the near term. This is shown in the chart below where technology sector outperformance, relative to cyclical small cap stocks, has followed the performance of long dated US Treasuries for much of the last decade.

However, since the start of the year the US yield curve has started to steepen and our medium term forecasts for higher treasury yields (more here) and a pick-up in inflation (and here) are tech stock bearish.

Another medium term headwind is the increased risk of new legislative proposals to reform and regulate the digital market. Just this week the CEOs of Amazon, Apple, Facebook and Google all agreed to testify before the House Judiciary Committee. This is the first hearing of its kind and the final step in the official antitrust investigation launched in June 2019.

Past performance is not indicative of future results. This is especially true of the tech sector. As such, we recently booked profits on the considerable gains made since inception, bringing our US tech position back to model weight. Our outlook remains near-term positive, albeit cautiously so, and we continue to monitor the situation closely in the run up to earnings season.