Big rally rests on a small base

A recent report from Goldman Sachs strikes a bearish note and suggests that although the big five stocks have added more than a third of their market value this year, the surge means that any slump would hit hard. Picture: AFP

Sharemarkets are rallying on the back of a dangerously narrow band of stocks.

In fact Wall Street’s climb back to where it was before the COVID crisis is based on just five stocks that now take up a quarter of US market capitalisation.

The reality behind the Wall Street rebound in recent months is that a swelling market capitalisation on the S&P 500 is almost entirely thanks to five outstanding stocks - remove them from the picture and the other 495 companies have gone backwards.

Global shares take their lead from US shares and the lead in US shares is now based on Apple, Amazon Alphabet (Google), Facebook and Microsoft.

The markets have not seen that level of dependence on a handful of stocks since late 1999, just before the dot.com crash.

Back then the US market - and as a consequence our own ASX - had been driven by the fortunes of five stocks (that represented 18 per cent of US market capitalisation): Cisco, General Electric, Intel, Exxon and - the only survivor on the list - Microsoft.

Remarkably, for investors on the ASX - which hit a two-month high this week - the narrow base the US is now trading upon merely draws level with the concentration that has always been a part of the Australian picture.

Just now, four stocks represent more than a quarter of the entire ASX 200: the banks CBA and Westpac, along with blood products group CSL and miner BHP.

But the arrival of excess concentration on the S&P 500 offers entirely different risks for investors everywhere - a major drawcard for the US market has traditionally been its healthy diversification.

David Bassanese, chief economist at the BetaShares group says one of the risks now is that fund managers, who often have a 5 per cent “cap” on any single holding in an individual stock, will be forced to sell out of the tech titans.

US analysts suggest that most international fund managers have already reached a 5 per cent maximum holding on Apple (which has more than doubled in price over the past year) while many managers might also be approaching limits on the other four key stocks.

A recent report from Goldman Sachs strikes a bearish note on the issue.

It suggests that although the big five stocks have added more than a third of their market value this year, the surge means that any slump would hit hard.

According to the investment bank: “For example, if the stocks declined by 10 per cent, in order to keep the trading flat, the bottom 100 S&P 500 stocks would have to rise by a collective 90 per cent.

“This dynamic explains why narrow market breadth has often preceded large drawdowns in the past.”

Nonetheless, Bassanese says that the big five stocks dominating Wall Street have got to the position through strong fundamentals.

“They were the growth favourites and now they have become defensive favourites and the price of these stocks is still within reason, they are not at crazy levels as we had before the dot.com crash.”

To compare, the five leading stocks in the US are on a forward price earnings ratio of about 34 times, excluding Amazon which is on 121 times. The top five Australian stocks are on a forward price earnings ratio of near 16 times, excluding CSL which is on 63 times.

As Bassanese suggests: “If I were to compare the current situation to anything it would not be dot.com era but the ‘nifty fifty’ period of the 1960s and 1970s when a bunch of blue chips dominated and they did so initially because they were the best. Of course ultimately that theme unravelled. As they say, all bubbles start with good intentions.”