Highlights:
- The S&P 500 Index increased by nearly 5% in May, bringing the year-to-date return to 11.3%.
- Reminiscent of the dot-com boom, a significant portion of the market’s return remains concentrated in just a few mega-cap technology firms.
- The return of rising interest rates has suppressed bond performance, with the Bloomberg Aggregate Bond Index down -1.6% year-to-date.
In the original parable of the blind men and the elephant, not only do each of the men describe the elephant based on a singular part, but they descend into discord arguing their perceptions. In the investing world, we have thousands of practiced eyes fixated on the same financial markets, often coming to a similarly bewildering range of conclusions. Even more puzzling are the times when a consensus appears widespread, only to be proved wrong as markets move to the contrary.
We note this not because this past month was one of those vexing inflection points but rather because markets were largely on the course to which we've become accustomed. The S&P 500 Index ended the month up just shy of 5%, bringing the year-to-date return to 11.3%. Fixed income bounced back with a 1.7% return in May. However, the return of rising interest rates has suppressed performance, with the Bloomberg Aggregate Bond Index showing a 1.6% loss so far this year. The domestic stock market continued to be led by a small number of mega-cap technology firms. Broader returns were fueled by a resilient economy, solid employment numbers, and enough suggestions for an economic slowdown and moderating inflation to maintain expectations of incipient Federal Reserve rate cuts.
Rising markets produce happy investors and tend to create snowballing enthusiasm and risk complacency. A deeper look into the market shows that over half of the S&P 500's return this year is concentrated in four mega-cap technology firms. This sort of concentration should be accompanied by at least a modicum of concern, but the more common reaction is a compulsion to join the trend powered by a fear of missing out.
How singular has the performance concentration become? At the peak of the dot.com boom of the late 1990s and into the 2000s, the S&P 500 became 29% technology-weighted. Looking past the recent reclassifications (from Technology to Communication Services, for instance), today's S&P 500 could be characterized as 40% technology. While some of this increase is secular (with virtually every company depending on technology and technological advancement), it's vital to be clear-eyed about the increased risk of performance concentration. During the ten-year period ending 12/31/23, the technology sector grew earnings at an annualized rate of just over 9% per year while producing an investment return of over 20% annualized, which meant that about half of the investment return came from an expanding price to earnings ratio from about 15x earnings to begin 2014 to over 36x earnings to begin 2024. In a higher interest rate environment, we would typically expect a contraction of price-to-earnings (P/E) ratios for the equity risk premium to compete against higher interest rates and higher bond yields. So far in this cycle, that contraction has not occurred. One thesis supporting technology upside from here despite high P/E ratios is an acceleration of earnings delivered via productivity gains from artificial intelligence.
Lagging bond performance this year has only added to the appetite for stocks with a natural inclination for the leading companies. Fundamental investment principles emphasize rebalancing -- trimming the winning assets and buying the lagging ones. We see this behavior from our most experienced and steadfast institutional accounts, even though it requires overcoming the emotional instincts of performance chasing.
Over the past months and years, we've demonstrated the ability to participate in a rising stock market while still emphasizing valuation and risk assessment. A big part of this discipline means keeping or even increasing fixed income allocations, as appropriate, at a time when immediate rewards may be lacking. We can celebrate new highs in the stock market while simultaneously noting that stock prices are increasing faster than earnings, creating P/E multiple expansion. We believe today's market only increases the imperative for thoughtful asset allocation and careful stock selection.