Driven by market frenzy and derivative trading, momentum stocks in the US have outperformed the benchmark S&P 500 index significantly since the beginning of this year.
This also reminds many institutions of the market conditions before the financial crisis, fearing that potential selling may drive the entire market down. Considering that small and medium-sized enterprises continue to face the threat of high interest rates and inflation, many strategists are concerned that fluctuations in momentum stocks, economic slowdown, and the Federal Reserve's shift towards expected volatility may mean that the risks of US stock market adjustments cannot be ignored.
The greatest advantage of financial crisis
As of last Friday's close, the MSCI US Momentum Index outperformed the S&P 500 Index by 11 percentage points in the first quarter of 2024.
Dow Jones Market Statistics found that this is the largest quarterly performance gap between the two since June 2008. Only three months later, the collapse of Lehman Brothers opened the most severe stage of the financial crisis. Another data shows that momentum stocks outperformed the S&P 500 index by 13.8% in the past two quarters, which is the largest leading edge in the range that momentum stocks have gained since the Internet foam reached its peak in March 2000.
Since last year, tech giants such as Nvidia, Meta Platforms, and Amazon have driven most of the gains in the S&P 500 index, and they now hold the highest weight in the momentum factor index. According to Goldman Sachs' previous calculations, the seven major technology stocks have accounted for over 30% of the weight of the S&P 500 index, approaching the record high set at the beginning of this century.
From the current target, momentum stocks are mainly composed of high-quality companies, namely companies with stable balance sheets and strong profit growth. Piper Sandler analyst Michael Krantowitz said that this can really distinguish the current situation from the era of the Internet foam. At that time, some momentum stocks may have negative returns.
Considering the impact of momentum stocks on the market, the Investment Director's Office (CIO) of UBS Wealth Management recently released a report stating that although the overall situation should not be ignored, investors need to remain neutral towards the US stock market. As investor sentiment and positioning improve, and valuations fully reflect various positive news, the market may experience a pullback in the future.
Morgan Stanley strategist Marko Kolanovic also warned in a report last week that after the recent investment boom in so-called momentum stocks such as the Big Seven, there is generally a pullback in history. "Momentum is a dynamic stock factor that changes its exposure based on macroeconomic and fundamental conditions. As a result, it often becomes crowded and inevitably undergoes drastic adjustments (i.e. momentum collapse)." He said that most companies in the United States and around the world are struggling to boost profits and maintain profit margins, with higher interest rates lasting longer and the halo effect of artificial intelligence stocks causing funds to flood into ultra large cap stocks. "Given this relationship, coupled with very optimistic investor sentiment and positions, we remind investors that this relationship may reverse when the artificial intelligence boom reaches its peak."
Does the Small Business Index imply risk?
While the three major stock indices are soaring, small cap stocks have become forgotten corners of the market. Since the beginning of this year, the Russell 2000 index has consistently underperformed the three major stock indices.
This may reflect the unfavorable situation faced by small and medium-sized enterprises. The National Federation of Independent Business (NFIB) stated that due to high prices and borrowing costs affecting expansion plans, the optimism of small businesses in the United States fell to a 9-month low in February, with six out of the past seven months experiencing a month on month decline. It is worth noting that as an important component of the economy, small businesses contribute about 40% of the US Gross Domestic Product (GDP), and the Russell 2000 index is the canary of the economy for the market.
NFIB Chief Economist Bill Dunkelberg said that although inflationary pressures have eased since peaking in 2021, small business owners are still dealing with the cost surge caused by rising prices and interest rates.
BK Asset Management macro strategist Boris Schlossberg said in an interview with First Financial that looking back at history, the weakness of small business stocks is one of several signs that investors are uneasy about the economic outlook, as they are often more susceptible to economic changes than large companies. "As the Federal Reserve enters the end of the tightening cycle, the disadvantage of relatively thin balance sheets puts pressure on small companies, and concerns about the economic outlook among businesses increase."
Schlossberg further explained that although the Federal Reserve reiterated its expectation of three interest rate cuts this year, there is still a lot of uncertainty based on recent economic data and official statements. For example, whether there will be any setbacks in the anti inflation process, especially the recent rebound in oil prices, as well as the resilience of the labor market and the degree of future slowdown in consumer spending, may have an impact on monetary policy choices and economic trends, thereby impacting risk appetite.
Goldman Sachs Asset Management believes that the short-term upward potential of the US stock market is "limited", and investors should seek better opportunities elsewhere. Although the baseline forecast is for the Federal Reserve to achieve a soft landing, James Ashley, head of international market strategy at Goldman Sachs Asset Management, remains cautious, stating that if a recession is imminent, it will be this year, "in other words, it's still too early."
Federal funds rate futures show that the market expects the Federal Reserve to take action as early as June. However, Ashley said that as the stock index has taken into account many expected policy relaxes, the recent bull market may have ended. "We do tend to believe that the current valuation of the US stock market is reasonable, with limited upward space. Other markets may have better opportunities, such as Japan and India," he concluded.