Unable to see the wood for the trees

Having risen almost 17% since the beginning of the year, the CAC 40, the Paris Stock Exchange’s flagship index, is riding high among world indices and setting a series of records. After a complicated year for the US technology sector, the Nasdaq is up 19%. Several other indices, particularly in Europe, are up by more than 10%, or as much as 15%. On the face of it, this paints a rosy picture for equity markets during the first third of the year. But like convergence lines intended to draw the eye to the main subject of the work, these performances shine a light on only one section of the market, leaving less glamorous realities in the shadows.

In the eurozone, one could highlight the strong outperformance of the luxury and consumer discretionary sector, which is particularly well represented in the CAC 40: Hermès, LVHM, and L'Oréal are nearing or exceeding a rise of 30%, while Kering and Christian Dior are up by more than 20%. Conversely, there has been a marked underperformance by small caps. Far from the 14% gain of the MSCI EMU Large Cap index, the MSCI EMU Small Cap index increased only 9% and the MSCI EMU Micro Cap index was up less than 5%.

Without a doubt, this phenomenon is even more obvious in the United States. Although the Nasdaq has jumped 19% since the beginning of the year, the S&P 500, the flagship index of the US stock market, has only gained a little over 8%. The Dow Jones Industrial Average and the Russell 2000 Smaller Companies Index are up just over 2%. For an investor in euros, this paltry performance has been fully offset by the fall of the dollar against the European currency. Such a dichotomy between the US indices can be chiefly explained by the strong rise in the major technology stocks. Apple, Microsoft, Amazon, Nvidia, and Alphabet, the top five stocks in the S&P 500, together generate 73% of the index's performance, even though they account for only 20%.

The result of this ultra-concentration in performance is a sharp reduction in market depth. In the case of the S&P 500, less than 25% of the index’s components have outperformed it over the last three months, compared to an average of around 50%. This is the lowest level since at least 2005 and reflects a degree of fragility. Firstly, it means that the rise is based on only a small number of stocks. Secondly, these stocks are essentially very large caps, suggesting that buy-side flows are largely driven by indexing – fuelled by trend-following funds or by algorithms – rather than by widespread investor optimism, particularly among fundamental investors.

In other words, this results in market positioning that can turn around very quickly if too much bad news were to accumulate. In the United States in particular, the need for the central bank to maintain a restrictive monetary policy in the face of slow disinflation, coupled with the gradual deterioration of macroeconomic data, creates an environment likely to provoke such a scenario. Investors will then no doubt be reminded that a few trees cannot hide the wood for long.