Two-Tier Markets, Full-Cycle Investing, and the Benefits and Costs of Defense
John P. Hussman, Ph.D.
“The Nifty Fifty appeared to rise up from the ocean; it was as though all of the U.S. but Nebraska had sunk into the sea. The two-tier market really consisted of one tier and a lot of rubble down below. What held the Nifty Fifty up? The same thing that held up tulip-bulb prices long ago in Holland – popular delusions and the madness of crowds. The delusion was that these companies were so good that it didn’t matter what you paid for them; their inexorable growth would bail you out.”
Forbes Magazine during the 50% market collapse of 1973-74
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Last week was a rather exasperating exercise in two-tiered markets; a type of divergence between the broad market and a handful of glamourous “concept” stocks that has often marked the wildest and most joyous points of reckless abandon in the market cycle, at least for speculators not tethered by traditional measures of value or historical experience. I’ll spare the list of names, which should be obvious to investors by their confetti.
Near the end of speculative runs, the market’s most glamourous concept stocks often carry significant market capitalizations, and therefore drive movements in the capitalization-weighted indices without broad participation from the rank-and-file. In the short-term, that can be uncomfortable for hedged-equity strategies that are long a broad portfolio of value-oriented stocks and hedged with an offsetting short position in the major indices. Even if the cap-weighted indices outperform the portfolio of individual stocks by a few percent, that difference shows up as a loss of a few percent in the overall hedged position. It’s easier to be patient when one recognizes that these episodes are temporary, and typically represent a significant red flag for the equity market.
A progressive internal deterioration of the market has been increasingly evident in recent months, and became severe last week. For example, the chart below compares the S&P 500 Index to the same 500 component stocks, but weighted equally rather than by market capitalization. While the difference may not seem significant, it also implies that even an equally-weighted portfolio of S&P 500 stocks, hedged with the S&P 500 index itself, would have lost several percent since mid-April.
The same observation holds for the Nasdaq index. The chart below is from analyst Cam Hui, showing the Nasdaq 100 Index along with the ratio of the equal-weighted index to the float-weighted index. What’s going on is that a handful of very, very large cap stocks account for an increasing share of the net gain, while the rank-and-file have been largely stagnant or in retreat.
Other measures of market participation have been equally problematic. The chart below compares the S&P 500 Index (upper red bars, left scale) with the percentage of stocks trading above their 100-day moving average (lower black bars, right scale). Fewer than half of all U.S. stocks remain above their 100-day moving averages, and only about half are above their 200-day averages.
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