The Download: 3Q 2024

Change is a constant in capital markets. History is littered with sudden shifts in trends, leadership changes, and unforeseen risk events. For that reason, past performance is an unreliable guide for future allocations.

3rd quarter takeaways

Concentration — The marketplace remains hyper focused on investing in U.S. large-cap stocks. However, most other equity assets outperformed U.S. large-cap stocks for the quarter.

Indexing — The indexing trend appears universal, but in the face of a change in leadership or a risk event, active management should shine again.

Risk is Not Dead — The concentration of investment in U.S. large-cap stocks, along with the concentration within the S&P 500^® Index has created an imbalance that historically has not boded well for future performance. A change in market leadership may eventually surprise investors, and many may find themselves over-invested in what could be an underperforming asset class going forward.

The Fed and Inflation — The consensus opinion appears to be that inflation is not a problem. Looking forward, though, it now appears that surprise inflation may be a more likely post the Fed Rate cut.

The Election — I did not mention the Election here, as we – like most other investment professionals – do not believe that the outcome of the presidential race reliably predicts or impacts future asset price prospects. That said, if we didn’t have a completed Election, that could be a problem.

Market concentration

The marketplace remains hyper-focused on the S&P 500 Index and U.S. large-cap stock investing. This focus is driven on three fronts: overall allocations to U.S. large-cap stocks, concentration within the S&P 500 Index, and investors’ preference for indexing in this environment.

Over the past 10 years, the S&P 500 Index – representing U.S. large-cap stock exposure – has nearly tripled the return of most other major asset classes. Strategies or investments that have outperformed over the past decade have likely all performed well for the same reason: they hold more S&P 500 Index or U.S. large-cap stock exposure.  That’s all; it’s that simple.

Investors only seem to want large-cap stocks

The current environment of market domination from one category of stocks is not uncommon. However, it is unusual for trends to continue indefinitely. Today, looking backward, the performance of the S&P 500 Index is a powerful persuader. For most investors, it is very difficult to now look forward and say, “The future might be different.”

Investors entering the market today or adjusting their current strategies are most likely focused on investments that have outperformed in the past. Investors reviewing their current investments often want to sell their underperformers to buy more of their winners, or winners they didn’t own. For individuals engaging in stock picking, they are most likely interested in the popular names of the day. All these endeavors would lead investors to one asset class: U.S. large-cap stocks.

When the home country is winning to this degree of magnitude, it is hard to escape the pull of past performance. This is the very definition of past performance chasing. It is human desire to own more of what has performed well in the past, right up until the point of change. But we are not time travelers, we must invest for the future.

The second level of concentration of U.S. large-cap stocks is the percentage of the S&P 500 Index that is held in the largest 10 stocks in terms of market cap. As it stands today, 36% of the S&P 500 Index is invested in just 10 stocks, which implies that the performance of this index is highly dependent on the prospects of just 10 stocks. This is not a comfortable situation.

S&P 500 Index top 10 stock concentration 

Nevertheless, the more money that flows into indexes, the greater these kinds of imbalances can become. The current levels of concentration within the S&P 500 Index present several challenges for investors. First, what investor has 36% of their wealth in just 10 stocks? Second, what active manager would invest this way?  Thus, the longer this trend continues, the harder and harder it is for investors – professional or individual – to keep up with the S&P 500 Index or benchmarks that are made up of indexes.

What has been investors’ answer to this problem? More performance chasing. Indexes, specifically the S&P 500 Index, are one of the only ways that investors can keep up with this type of market, as most active managers are not willing or want to hold upwards of 40% of their assets in the 10 largest stocks. Counterintuitively, instead of recognizing the imbalance of concentration, the main driver of capital into the S&P 500 Index has been investors pivoting from active management to passive management.

Where has the money come from?

Investors may have forgotten that active management is a representation of teams of investment professionals providing research and decades of experience, investment processes, and intellectual property, all aligned to provide conscientious and purposeful investment management for clients. On the other hand, indexing represents simple exposure to a market-based formula. Indexes don’t care what they buy, at what price, and for what reasons because indexes are just a formula providing market exposure. Paradoxically, most indexes are market cap weighted; the higher the security price, the more they own (buy high momentum strategy). By choosing indexes here and now, investors are arguably voting for, “give me more of what has performed well in the past”.

This is all good as long as current trends continue. However, in the face of a change, or any form of risk, investors might be wishing they had thought more about owning active managers that are at least concerned with risk management and security selection.

So what’s the risk?

Market concentration and performance chasing do not occur without significant risks. Historically, this type of concentration has proceeded long and protracted periods of underperformance for the S&P 500 Index and U.S large-cap stocks. And rightfully so. This type of investor concentration has only occurred at the end of long trends of outperformance when the S&P 500 Index reached near historic levels of overvaluation and when investors became indifferent to investment selection and resorted to past performance chasing. Specifically, the most concentrated the S&P 500 Index has ever been was in the years 1929, 1965, 1973, and 1999. All these time periods were followed by the worst decades on record for the S&P 500 Index.

The second risk for investors is a less damaging but more likely outcome: a change in market leadership. In the 3^rd quarter small-cap stocks and international stocks actually outperformed U.S. large-cap stocks according to generally accepted indexes.

We have been on the precipice of change before. In the late 1990s, the U.S. stock market exhibited similar characteristics as today. Back then, the internet was going to change the world, and any stock associated with the internet was off to the races. Investors scrambled to keep up, and indexing and individual stock ownership in popular names was rampantly popular. Today, the story looks the same; just replace the word “internet” with “AI.”   We all know what followed the late 90s euphoria: the Tech Wreck. In 2000, the U.S market broke for no apparent reason, and U.S. large-cap stocks and the S&P 500 Index underperformed most other equity assets by a wide margin for over a decade. This story of leadership changes is as old as financial time.

The Fed, China, and inflation

For many investors, the biggest story for the quarter (followed closely by Nvidia’s earnings) was the Fed cutting the Fed Funds rate by 0.5% and signaling that they intend to cut another 0.5% by year-end. This was a surprisingly positive but aggressive move. On the surface and in the short run, this all sounds good for both stocks and bonds, and this was evidenced by this quarter’s solid market returns.

Unexpected market moves since the Fed rate cut 

However, another surprising but positive event during the quarter was that the PBOC (Central Bank of China) followed the Fed’s action and set off a barrage of stimulative measures to combat their current economic and asset price malaise. After the Fed’s rate cut, China has been the best-performing major stock market in the world. Interestingly, China’s economy has historically been a major, if not the major, driver of commodity prices. For the last 2 years, China’s economy has been in a recession, and thus, their demand for resources has been muted. To what degree will a China economic resurgence impact commodity prices and inflation this time around?

We are now left with accommodative central banks lowering interest rates in the U.S., Europe, and China, which is global economic stimulus. Coordinated global growth can keep demand for goods and services above expectations, which can impact inflation. Finally, there are still two wars being fought, and wars are inflationary. I wouldn’t count out inflation just yet, and inflation at this point could be construed as a negative surprise.

Frontier positioning

Frontier strategies remain risk-averse and have diversified postures. As a firm with a risk-first approach, we remain vigilant about potential challenges. In an environment where few seem concerned, any disruptive event could have significant consequences. Secondly, due to the imbalances of market concentration, we continue to expect a change in leadership away from U.S. large-cap stocks to a broader outcome that should more greatly benefit most other equity assets. Finally, while we also invest in indexes, our portfolios are primarily constructed by allocating to a select group of active mutual fund managers whom we consider to be among the best. We believe we are one of the few firms using this approach and we believe that our positioning will be of great value to investors.