MorningWord 12/30/15: The Path of Least Resistance is No Longer Higher

by Dan December 30, 2015 11:22 am • Commentary

On the last day of 2014 (here) I took issue with a quote in the WSJ regarding the U.S. stock market, “probability of a solid 2015 is improving“.  If I were a full time market pundit, or was in the business of selling stocks as an asset class to potential investors, that would probably be my go to un-falsifiable comment.  Thankfully that is NOT the business that I chose, and my view at the time has remained consistent throughout 2015:

But from where I sit there is one current disconnect in the global economy that could signal a massive monkey wrench for a solid 2015 for stocks, and that is the crash in oil prices. The general consensus is that lower oil should strengthen global equities, with many pointing to the recent rally to prove that point. But I suspect seasonality (holidays) had something to do with the uptick we saw in consumer related industries in the U.S. and the realization of lower for longer crude speaks to far worse forecasts for the health of the global economy.


So from purely a mathematical standpoint, risk assets over time have a high probability of “improving” but it would be foolish not to consider the growing divergences among asset classes and geographies as we enter 2015. Also consider the fact that the risk / reward to committing new capital to equities after such a sharp rally in just the last 2 months seems sub-optimal.

Aside from the Nasdaq’s 7% year to date gains, the only major equity markets that are up in 2015 are those whose central banks are continuing QE and weakening their currencies, Japan’s Nikkei up 9%, China’s Shanghai Comp up 10%, The Euro Stoxx 50 up 5% and the German DAX up 9.5%.  The S&P 500 (SPX) has stalled in 2015 since the U.S. Fed ended QE in Q4 2014 and put an official end to 7 years of ZIRP with their first rate increase this month since June 2006. You get the picture.

On more than a few occasions in 2015 I have highlighted what I deem to be a very unhealthy concentration in ownership and performance is U.S. stocks among a handful of high growth / valuation leaders. I am not gonna go into great detail here, but I do find this one stat regarding the Nasdaq 100 (NDX) fairly troubling.  The stocks that make up the NDX have a $5.3 trillion market capitalization. The NDX is up 10.3% in 2015, or gains of roughly $550 billion.  Not bad, but when you consider the fact that Alphabet (GOOGL), Amazon (AMZN) and Facebook (FB) make up about 20% of the weight of the NDX, and that those three stock’s year to date gains equal about $600 billion in market cap, its starts to paint a fairly dim picture about the current health of, and the potential continuation of the 7 year bull market in the Nasdaq.

Here is the NDX over the last 20 years on a log scale:

NDX 20 year log chart from Bloomberg
NDX 20 year log chart from Bloomberg

We are back. I know, I know, it’s very different this time when you consider the profitability and multiple of sales of the stocks that make up the index, implying much more reasonable valuations. But what has not changed is the concentration within the index in a handful of stocks, and we know how that ended in 2000.

Looking at the S&P 500, we can see from a chart from Bespoke that when one sector becomes more than 20% of the S&P weighting (as was the case with Tech in 2000 and Financials in 2007/08) they ultimately become the epicenter for future weakness:


Tech now makes up about 20% of the SPX, and Apple (AAPL), the largest weighted stock in the index (equaling 3.3%), per the WSJ in July, has “single-handedly give the tech sector all of its earnings growth” in the first half of 2015, and in Q2 edging tech to year over year growth “just edging it up by 0.2%. Without Apple, the sector would see a contraction of 6%.”  Since 2011:

Apple, for every single quarter, has comprised no less than 3% of the S&P 500′s operating earnings, according to data from S&P Dow Jones Indices. It accounted for 2.87% of the index’s operating earnings of $25.29 in September 2011, and has ranged higher since then. In the first quarter of 2015, it comprised 5.97% of the $25.81 operating profit. In the fourth quarter of 2014, it was 7.62% of the $26.75 profit.

Think of its this way. If all 500 of the companies in the index contributed an even amount, Apple’s earnings would account for about 0.2% of the overall profit. On the contrary, Apple is by far the single biggest contributor to the index’s earnings.

While AAPL is down 2.5% on the year and clearly not assisting in NDX performance (about 11% of the NDX weight), its earnings contribution has been massive, and with its growth decelerating meaningfully in fiscal 2016 from 43% last year, to an expected 5% in 2016, a worse than expected slowdown with lower than expected buybacks could do a number on S&P 500 earnings.

Obviously the loss of energy earnings has already done a number on S&P 500 earnings. Consensus coming into the year was for about $120 a share, and now its expected to be about $111 share. If energy earnings remain depressed, and tech and financials don’t pick up the slack then an earnings recession could speak to an impending economic recession.  In that scenario I am hard pressed to think that the SPX does not re-test its 2013 breakout level near 1600 at some point in 2016:

SPX 20 year log chart from Bloomberg
SPX 20 year log chart from Bloomberg

I hate to be the bearer of bad news, but the ingredients that made the seven year bull market possible have become stale. And the likelihood of a handful of high valuation concentrated holdings being able to squeeze out the next massive leg higher is increasingly unlikely. Could this group of stocks have one last dash higher like they did in early 2000? Certainly, but without the participation of a broader group of stocks and sectors that rally would be born into a grave.  The risk reward for committing new capital (right now) to U.S. stocks is poor, which has been the case for most of 2015 (aside from a small group).  The path of least resistance is no longer higher for U.S. stocks (as was the case at this time in 2014).