This awfully fragile narrow no-good rally

The S&P 500 is up nearly 8 per cent this year, but unease around the underlying strength of the rally is almost palpable. People really bloody hate it, basically.

JPMorgan’s equity analysts are among the haters. They estimate that the breadth of the US equity rally is “by some measures is the weakest ever”, with the narrowest leadership in a rising stock market since the 1990s.

Microsoft and Apple alone are behind about 2.3 per cent of the S&P 500’s gain this year and now account for a record 13.4 per cent of the index — the most ever for the top-two stocks.

There’s also a rotation into perceived safety (bigger and steadier stocks), and a herding into anything that is perceived to gain from the the hype around generative AI.

JPMorgan’s equity strategists argue that the AI “theme appears to be stretched”, given how its generated about $1.4tn of market cap this year.

The overall conclusion is that stonks are whistling past a possible recession. JPM’s emphasis below:

… The current degree of crowding implies the risk of recession is far from priced in. While in 2021, a broad market rally led by Cyclical factors (Growth and Value) drove concentration to the highest level seen since the Nifty-fifties, the current market concentration episode is less constructive for the broader market given:

– Mega-cap crowding with market cap of largest 10 stocks relative to S&P 500 at 96%ile relative to history (see Figure 1). Weight of largest two stocks as % of S&P 500 index is at new highs. Last quarter’s performance was led by the narrowest leadership ever in an up market (see Figure 9 and Market Concentration Section);

– Growth leadership narrowing. Popularity of ChatGPT was a catalyst for bidding up select AI stocks to a record concentration and contributed to low breadth move up in major indices. Year-to-date these six LLM Innovation companies MSFT, GOOGL, AMZN, META, NVDA, CRM explain 53% of S&P 500 performance, 54% of Nasdaq 100 and 68% of Growth factor; and

– Defensive rotation ongoing with rising correlation of Momentum with Low Vol / Quality while the correlation with Value is collapsing.

So why is the stock market not just buoyant but also so calm? In a separate note published yesterday, JPMorgan analysts dug into the odd lack of choppiness, with one-month realised volatility for the S&P 500 falling to 9 per cent for the first time since 2021.

Tl;dr they argue that vol is “artificially low” primarily because of option dynamics and the procyclical nature of volatility-targeting investment strategies.

We believe the reasons for low volatility are technical in nature with the market dominated by option sellers. Selling of options forces intraday reversion, leaving the market price virtually unchanged many days. This in turn drives buying of stocks by funds that mechanically increase exposure when volatility declines (e.g. volatility targeting and risk parity funds). This market dynamic artificially suppresses perceptions of macro fundamental risk. The low hurdle rate and robust fundamentals bode well for 1Q earnings results, but we advise using any market strength on reporting to reduce exposure.