Chief Investment Strategist
Summary: If equity market momentum and the VIX forward curve were the only two indicators worth looking at then one would be an optimist, but outside the spectacular momentum of mega caps, the equity market is signaling disruption. S&P 500 index concentration has risen to the highest levels on record and the mega caps outperformance is on par with previous major market turning points.
The VIX Index, measuring the 30-day expected annualized volatility in the S&P 500 Index, closed at 13.96 yesterday, a significant drop from 18 over just four trading sessions. This level was the lowest recorded in the VIX Index since the pandemic changed financial markets reflecting low levels of stress in US equities. There is a growing debate about the apparent calm equity market the past six months and the growing evidence of the economy slowing down and potentially headed into a recession. Many classical signals on the economy and especially those from the bond market are clear on the direction, but somehow the equity market is completely disagreeing.
The VIX Index itself has no predictability on future equity return, but the VIX futures forward curve has shown to improve return predictability. If we look at the spread between the 2nd nearest VIX futures contract and the VIX Index then the current spread is 3.4 points, which is right on the longer term average, the VIX forward curve is typically in contango (upward slopping). This level of contango is typically associated with positive equity returns so the equity options market is sending the signal that equities could extend their momentum. Earnings estimates are also reflecting the same optimism rising considerably throughout the Q1 earnings season as the outlook from companies has been much more optimistic than feared.
November 2021 marked a peak in US equity market concentration since 1991 although MSCI data suggests that the US equity market also experienced a dramatic peak in index concentration back in 1977. As the interest rate shock ran its course in 2022 pulling US technology stocks back to earth causing a significant reduction in the S&P 500 index concentration we were quite sure that the market had turned a corner in terms of index concentration. Never in our wildest imaginations would we have guessed that the index would roar back to new highs as of last Friday driven by an excessive AI-related rally in technology stocks. But the facts are what they are. The S&P 500 has never been more concentrated with the 10 largest stocks constituting a combined index weight of 30.4% as of last Friday. This is obviously not a good sign because it makes the US equity market more fragile and sensitive to small changes in sentiment in a few stocks. High index concentration also tends to be correlated with big breaks in financial markets as they transition to a new regime.
While the equity indices are telling a different story than the one promoted by economists and the bond market there is one catch. The leading equity indices are all market-cap weighted. As the index concentration has risen so has the signal value from the equity market fallen, at least if you are only paying attention to the S&P 500. Beneath the surface of mega cap stocks the ocean of smaller stocks is telling a different story. The current is much cooler reflecting the realities in the economy.
The long-term relative performance between the S&P 500 and the S&P 500 Equal-Weight has been negative meaning that from the dot-com bubble days to around 2014 the equal-weighted index outperformed the market-cap weighted index. In other words, the smaller cap stocks outperformed. At around 2014 the cycle of index concentration accelerated and the S&P 500 has done better than the equal-weighted. The long-term trend is less important than the changes in the relative total return index over 26-weeks. Here we can see that S&P 500 has currently outperformed the equal-weighted index by 8.6% which is equal to the changes observed during the early days of the pandemic, the turnings points during the Great Financial Crisis (in November 2008 and March 2009), and during the LTCM crisis and the height of the dot-com bubble. So the market behaviour we are observing today has occurred during some of the most profound turning points in equity markets the past three decades. Where we go next is uncertain, but something big is happening under the surface of equity markets.
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