There's Something Strange About Stock Market Concentration: Morning Brief

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The major indexes may have posted only modest gains on Wednesday, but while the generals slept, the soldiers were on the march.

At the forefront, moderate losses in the energy and large-cap financials sectors were offset by exceptional gains in the consumer discretionary sector, led by Amazon (AMZN) and Tesla (TSLA) .

This seesaw theme has become a subtle but important market narrative. On days when AI isn't leading the charge, some pockets of strength prevent the S&P 500 from deeper selloffs, keeping the index's volatility near multi-year lows.

Nvidia’s recent “plunge” is instructive.

On Monday alone, AI Branding closed 13% lower than its all-time high. Judging by social media, you'd think Wall Street was on fire.

But during that terrible three-day slump, a funny thing happened: The Dow Jones Industrial Average (^DJI), up just 3% this year compared with 14% for the S&P 500, came back. Energy rallied and biotech surged as forgotten pockets of the market showed signs of life.

This compensatory swinging behavior is pervasive today, to the detriment of correlations between stocks in similar sectors. Stocks just don't want to move in the same direction.

“This is a generationally weird American stock market,” wrote Luke Kawaformer Director of Investment Solutions at UBS Asset Management Americas, now at Sherwood Media.

Kawa was specifically referring to Tuesday's price action, in which the S&P 500 managed a 0.4% gain despite 384 of its components closing in the red, a new feat for a data set dating back to 1996.

Similar “firsts” have recently littered market statistics.

But none of this undermines the argument supported by much research and history that it is perfectly normal in a bull market for gains to be concentrated in a few stocks.

Winning stocks that benefit from a secular-themed rally get bigger and bigger until the move runs its course.

In a bull market, when major stocks decline, other parts of the market that don't necessarily make headlines can rise to the occasion. Sector rotation keeps volatility low at the index level as new winners offset losers. Then, at some point, the music stops and all sectors start selling in unison, triggering a new bear market.

Kawa linked this to the current market, write that “Different major groups within the U.S. stock market have recently been following their own rhythm, and that dynamic has helped keep the stock market from taking a sharp decline.”

The story continues

We are currently seeing disparate returns not only across sectors and industries, but also within sectors, even among very large-cap technology stocks. Over the past six months, while some of them, like Microsoft and Alphabet, have advanced, Nvidia and Apple may have slipped. The correlation between directional movements between pairs in this cohort is just 43 percent, Kawa noted.

All these zigzags keep index-level volatility at bay, but Kawa exhibits The major risk in this environment: a “correlated shock” which would be distributed “among these companies which control a large part of the American and global stock indices”.

Even if the “big drawdown” remains the central risk, divergences can persist longer than arbitrage investors can remain solvent (to turn a old wall street trope).

In fact, research by BofA's data analytics team suggests that the current regime of low inter- and intra-sector correlation may persist for years.

“Several years of decorrelation in the 1990s, as the dot-com bubble grew, suggest that the persistence of the current regime remains a risk,” BofA writes.

As a result, the outsized bifurcation of returns between AI's privileged few and the rest of the market need not end happily.

“Just because we're in uncharted waters doesn't mean we're heading toward a waterfall. This could end up being a lazy river,” wrote Coffee.

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