WHEN WILL THE POT BOIL?

Eliminate the impossible and what remains, no matter how improbable, is your answer.

It’s a line by Sir Arthur Conan Doyle, written for his fictitious detective Sherlock Holmes.  It’s routinely useful in the stock market.

Improbably or not, the market keeps racing higher on the back of a handful of mega-cap stocks while volatility hovers at multi-year lows. In modern markets, it’s machines that set the price (with narratives following). Can these dynamics somehow be related?

We think so. It appears more than plausible.

Mega-Cap Distortion

2023 was an excellent year for the S & P 500 Index (SPX) yet the vast majority of gains came from essentially seven stocks with the largest concentration in the index in terms of market capitalization.

The surge in those stocks has skewed the performance of the broad market index. The performance of the bottom 493 stocks was markedly different.

Here is data from late-December 2023:

Clearly a rising tide has not lifted all boats.

As shown below, for each $1 invested in SPX, $0.35 flows directly into the top 10 stocks. The remaining $0.65 is divided among the remaining 490 stocks.

The rise of exchange-traded funds (ETF’s) and surge in assets under management means passive index shares have swallowed a massive portion of inflows. Out of roughly 1750 ETF’s the top 10 stocks in the index comprise approximately 25% of all issued ETF’s. 

Over the past 14 years the unprecedented flow of liquidity, both monetary and fiscal, is the direct result of government manipulation. Approximately $43 trillion has been injected into the system to help fuel economic growth.

Machinations

For investors, this flood of liquidity, combined with passive indexing, has changed market dynamics over the past decade and pushed investors to become increasingly exposed to the same stocks, nearly everywhere.

Because of its heavy weighting within SPX, the rising tide of Technology has created a mirage of overall market performance. The rise of index funds has turned everyone into “asset class pickers” instead of stock pickers.

With the concentration of risk in a handful of stocks, the markets are set for a vicious cycle downward, perhaps beginning this year. Whatever causes the reversal, it is sure to set off a stampede for the exits, akin to yelling “fire!” in a crowded theatre. There will be little regard for price, valuation, or fundamentals as the exit narrows.

The rise of machines in stock trading has forever changed the investment landscape. Over 90% of trading volume is motivated by something other than business fundamentals. About 50% of it is motivated purely by price. Citadel’s market-making business, for instance, makes billions of dollars annually by changing the price of things and taking a fraction of a penny per share. Fees, so to speak, for crossing the spread between bids and offers to fill trades.

About 20% of market volume is tied to derivatives like options. This is largely hedging activity from Option Liquidity Providers (OLP’s).

And the remaining 20% of volume is motivated by stocks as products, or indexation. ETF’s, index funds, quants like CTA’s and volatility-control funds. This is the investment engine of the market today, but it’s nimble and tends to shift much more quickly than long-term money from “thinking” investors.

Volatility Crush

The chart below shows the topology of volatility versus SPX price: The white line is price, and purple is the ratio of 2-month vs. 6-month realized volatility during 2023:

Zooming in on one of the most important mechanical aspects of price direction, you can see in the lower right corner that volatility is just about as low as it gets. When 2-month realized vol is lower than 6-month, it is easier for stocks to climb as many quantitative strategies perceive this as a measure of market safety.

Additionally, many quants like vol-control funds (often insurance companies and pension plans), look to the relationship of 1-month to 3-month realized volatility as a trigger for market exposure.

While volatility remains low these funds will hold equities, but it becomes a powder-keg when vol starts climbing back up.

The chart above shows a recent snapshot of 5-day volatility. The red line pressing down against the bottom of its range shows the natural ebb and flow of short-term vol, but it’s also reasonable to expect the next directional move to be up, exerting a bearish influence on equities.

In conclusion, the boat is heavily tipped toward a mega-cap low-vol market regime right now, but a rogue wave is probably energizing somewhere beneath the surface.

Not impossible.