Just Six HOT Stocks Are Driving Returns

The banking crisis that started in early March marked a major sea change for the markets. The most profound impact has been felt in the bond market, which has seen interest rates drop precipitously across the yield curve. The yield on the 10-year Treasury has dropped from a 2023 high of about 4.08% on March 2 to the current 3.44%. The shorter end of the Treasury curve has seen an even bigger move, with the yield on the 2-year Treasury falling from a high of about 5.06% in early March to about 4.03% today. And the Fed Fund futures market, from which we can glean expectations for future overnight lending rates among banks, is currently pricing in a Fed Funds rate of just 4.51% in December – down around 105 basis points from March 8 (the day before Silicon Valley Bank collapsed). These interest-rate drops reflect a belief among investors that the turmoil in the banking industry will: 1) cause banks to hoard capital and therefore inhibit the free flow of credit; and 2) cause the Fed to cease interest-rate hikes and begin cutting rates much sooner than previously expected. 

The crisis has also affected the equity markets, even though the impact may not be seen at the major index level. In fact, despite an initial swoon over bank fears, the S&P 500 and Nasdaq have actually added to their year-to-date gains since the banking crisis began, rising 3.6% and 4.9%, respectfully, since March 8. Digging a bit deeper, we can get a better picture of what’s going on. The chart below shows the dramatic divergence in performance by industry sector within the S&P 500 this year. The Financials, as might be expected, have performed worst after taking a major hit in March on the bank failure news. Energy has fared poorly as well following a strong 2022, perhaps reflecting worries about an economic deceleration ahead. But look at where the money has been going. Stocks in the Communications Services, Technology, and Consumer Discretionary sectors have surged this year even as economic fears have grown. To what can we attribute this rotation back into the sectors that led the markets lower in 2022? 

The explanation is that money has been pouring into the same mega-cap stocks that drove performance for so long while the Fed kept interest rates pegged close to zero. Investors believe that the FAANGs and their ilk will serve as a port in any storm that may come. They believe so because most of these companies have rock-solid balance sheets and can provide highly visible earnings growth during periods when growth becomes scarce. And, importantly, the opportunity cost of owning these growth stocks goes down when interest rates are low. 

In the table below I show the six mega-cap names that have been driving the markets this year. Their combined market capitalization now makes up about 23.5% of the entire S&P 500 compared to 19.0% at the end of 2022. The six stocks have put up an average return of 49.1% this year. That performance compares to just +8.3% for the S&P 500 and +2.1% for the equal-weight S&P 500 (which assigns a 0.2% weighting to each stock in the index). If we use each stock’s actual weighting in the index as of December 31, 2022, the six stocks accounted for 6.5 percentage points, or 78%, of the YTD index return. In other words, the S&P 500 would be up just 1.8% this year if not for these six stocks’ contributions. 

It’s hard to say whether or not this stock rotation is a healthy development. On one hand, I suppose it’s a positive that the mega-caps are keeping the major market averages from falling in response to this economic shock (bank crisis). The overall demand for stocks hasn’t declined, it’s just been redistributed. On the other hand, the lack of market breadth and increased unwillingness to own bank and other cyclical stocks suggest that economic concerns are growing. The silver lining, of course, is that rising economic concerns will also cause the Fed to relent…eventually. The markets already seem to be sniffing that out already. Keep in mind the Fed won’t lower rates until the economy stalls. As we’ve written before, be careful what you wish for.