Mad Hedge Technology Letter
October 30, 2023
Fiat Lux
Featured Trade:
(WHY MEGACAP TECH IS THE ONLY SHOW IN TOWN)
(BIG TECH), (ETF), (COMPQ)
Mad Hedge Technology Letter
October 30, 2023
Fiat Lux
Featured Trade:
(WHY MEGACAP TECH IS THE ONLY SHOW IN TOWN)
(BIG TECH), (ETF), (COMPQ)
Megacap stocks continue to make hay when the sun shines in 2023.
The question is, why?
After all, many other great companies have arguably much better valuations, fundamentals, and affordable PE ratios.
Big tech stocks are expensive, yet buyers keep maneuvering to bid up the stock.
What gives?
The surge in the most hated sectors last year has been the main driver of this year’s stellar equity performance.
If we strip out tech, performance is actually negative if you can believe it.
The question is, why are professional managers seemingly chasing big tech like no other stocks exist?
The answer is more simplistic than you may think.
For investment managers, generating “alpha” is necessary to limit “career risk.”
If a manager underperforms their relative benchmark index for a time that is noticeable, they start to get in the firing line.
Currently, there are two drivers for the mega-capitalization stock chase. First, these stocks are highly liquid, and managers can quickly move money into and out without significant price movements.
The second is the passive indexing effect.
As investors change their investing habits from buying individual stocks to the ease of buying a broad index, the inflows of capital unequally shift into the largest capitalization stocks in the index.
Over the last decade, the inflows into exchange-traded funds (ETFs) have exploded.
That ETF issuance surge and the assets’ growth under management fuel the performance of the top 10 stocks. As we discussed previously:
Therefore, as investors buy shares of a passive ETF, the shares of all the underlying companies must be purchased.
Given the massive inflows into ETFs over the last year and subsequent inflows into the top-10 stocks, the mirage of market stability is not surprising.
Given stick high interest rates, inflation, and reversal of monetary liquidity post-pandemic, the risk of recession is higher than normal.
Higher interest rates, in particular, currently pose the largest threat to small and medium-sized companies.
The largest 10% of companies represent 62% of the overall non-financial market cap of the S&P 1500.
Smaller firms do not have the massive cash balances the megacap companies hold which puts them at a disadvantage.
As that debt wall of term loans hits over the next few years, higher borrowing costs are going to raise the risk of defaults and bankruptcies.
Tightening financial conditions have seen corporate bankruptcies rise by 71% since last year. If financial conditions are still elevated over the next few years, that bankruptcy risk increases markedly.
They weren’t able to lock into long-term loans at almost zero interest rates and pile it high in the money markets at variable rates.
Ultimately the pain for US small- and mid-cap companies will trigger the recession.
Portfolio managers must chase the market higher or potentially suffer career risk. Therefore, the easiest place to allocate cash is the mega-capitalization companies with low risk of bankruptcy or default and extremely high liquidity.
With the concentration of risk in a handful of stocks, the markets are set for a rather vicious cycle.
The concentration at the top keeps getting worse and I do believe we are one cycle away from the top 7 tech stocks comprising 35% of the total equity market.
It’s quite bizarre that something even remote could materialize, but that is where we stand where investors are looking for safety.
Throw in that most investors with a high net worth aren’t young, the tendency to go with a more conservative approach will shine through.
Funnily enough, tech investments in the big 7 constitute as conservative and it’s really true when I say that big tech has aged with its investor base.
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