The U.S. stock market hit pause in early September, as investors took a harder look at market overconcentration and frothy sentiment. Meanwhile, global economies may be entering a new phase, and the Federal Reserve’s newly announced inflation policy is likely to keep U.S. rates lower for longer.
U.S. stocks and economy
With the recovery showing some signs of stalling in certain areas of the economy, the U.S. stock market’s rally took a breather. Pushed by momentum chasing and excessive froth in measures of sentiment and the options market, U.S. stocks’ climb to new highs reversed course at the beginning of the month. The Information Technology sector was hit hard as investors rotated into more traditional cyclical sectors, as well as into some defensive areas like utility stocks.
Much of the risk leading up to the recent selling pressure was related to overconcentration. As you can see in the chart below, the largest five stocks in the S&P 500® Index recently accounted for nearly 25% of market capitalization, while for the Nasdaq Composite (note the data is limited and the series starts later), it was a more staggering 38%.
The top 5 stocks continue to dominate as a percentage of market cap
Source: Charles Schwab, Bloomberg, as of 9/9/2020.
Compared to the tech bubble that formed in the late 1990s, the largest companies now have more solid fundamentals. However, the risk associated with their dominance is that any rotation out of them—like we saw earlier this month—could lead to a more amplified downturn in the broader market.
August saw the S&P 500 and Nasdaq 100 (which is a basket of the 100 largest, most actively traded non-financial stocks in the overall Nasdaq) hit a number of new all-time highs, while volatility was simultaneously rising. As you can see in the next chart, both volatility measures that track each index remain elevated relative to pre-pandemic levels and were increasing alongside stocks. It was a head-scratching feature of the most recent bull market, but partly explained by coming election risk, which elevated the cost of October volatility contracts relative to the spot price.
Volatility rose along with stocks
Source: Charles Schwab, Bloomberg, as of 9/9/2020. Past performance is no guarantee of future results.
Internals within the market—like the previously mentioned concentration risk—were flashing warning signs. As fewer names made new 52-week highs and/or were trading above their 50- and 200-day moving averages, the market’s backdrop grew weaker as participation narrowed. This again highlighted the strength of just a few of the largest names.
A bifurcated picture has more or less been the same in the economy, as some areas like housing and retail sales have already bounced back above pre-pandemic levels, while restaurants and other small businesses struggle to navigate reopening and hiring back employees. As we saw in the August U.S. jobs report, the pace of job growth has slowed. You can see in the chart below that permanent job losses have increased to 3.4 million, while those on temporary layoff have fallen to 6.16 million (down from their peak of 18 million in April).