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The major indexes may have made only small gains on Wednesday, but while the generals slept, the soldiers were on the march.
At the forefront, modest losses in the energy and corporate finance sectors were offset by outsized gains in the consumer discretionary sector – mainly thanks to Amazon (AMZN) and Tesla (TSLA).
This see-saw theme has become a subtle but important market story. On days when AI doesn’t take the lead, select areas of strength keep the S&P 500 from more pronounced sell-offs – itself pushing index volatility near multi-year lows.
The recent “dive” in Nvidia is instructive.
On Monday alone, the AI poster child closed 13% lower than its all-time high. If you examine social media, you would think Wall Street was on fire.
But during that harrowing three-day slump, a funny thing happened: The Dow Jones Industrial Average (^DJI) — up just 3% this year versus 14% for the S&P 500 — staged a comeback. Energy surged and biotechnology took off as forgotten parts of the market showed signs of life.
This see-saw compensating behavior is currently everywhere rather than correlations between even stocks in similar sectors. Stocks simply don’t want to move in the same direction.
“This is an American stock market that has been alien for generations,” wrote Luke Kawa, a former director of investment solutions at UBS Asset Management Americas and now at Sherwood Media.
Kawa was specifically referring to Tuesday’s price action, in which the S&P 500 posted 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 been all over the market statistics lately.
But none of this detracts from the argument – backed by extensive research and history – that it is perfectly normal in a bull market for profits to be concentrated in a few stocks.
Winning stocks enjoying a secular-themed rally get bigger and bigger until the move runs its course.
In a bull market, when leading stocks falter, other parts of the market that might not generate hype-filled headlines can rise to the occasion. Sector rotation keeps index-level volatility low as new winners offset losers. And then, at some point, the music stops and all sectors start selling off at once, creating a new bear market.
Linking this to the current market, Kawa wrote that “several major groups within the U.S. stock market have been marching to the beat of their own drummers lately, and this dynamic has helped keep the stock market from plummeting violently.”
We are currently seeing divergent returns not only across sectors and industries, but also within them – even among the mega-cap tech stocks. If some of them, say Microsoft and Alphabet, are up in the last six months, Nvidia and Apple might be down. The correlation between directional movements between pairs in this cohort is only 43%, Kawa noted.
All this back and forth movement keeps index-level volatility at bay, but Kawa points to the biggest risk in this environment: a “correlated shock” that is spread “among these companies that control a large portion of the US and global equity indexes.”
While the “big drop” remains the primary risk, the differences could persist longer than arbitrage investors can remain solvent (to invert an old Wall Street trope).
In fact, research from BofA’s data analytics team shows that the current regime of low inter- and intra-sector correlation could continue for years.
“Multiple years of decorrelation in the 1990s, as the Internet bubble developed, suggests that the survival of the current regime remains a risk,” BofA wrote.
Accordingly, the excessive split in returns between the chosen AI group and the rest of the market need not end with a bang.
“Just because we’re in uncharted waters doesn’t mean we’re headed for a waterfall. It could end up being a lazy river,” Kawa wrote.
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