24 mai 2017

Are Developed Markets a Concentrated Bet on US Tech Stocks?

May 24, 2017, Jean-Jacques Ohana and Dr. Christian Witt (both YCAP Asset Management)

Developed markets, not their emerging peers, have been the primary source of equity returns over the last five years (see Figure 1). The MSCI World, a proxy for the performance of global developed equity markets, accumulated nearly +80% of performance, easily surpassing the +25% gain in emerging market stocks. As we have argued lately, investors should closely monitor emerging market stocks for their more favorable long-term economic prospects, cheaper valuations and diversification potential. But performance greatly matters, of course. So, investors also need to understand where the (out-)performance of developed market stocks comes from and what its implications are going forward. Our take is recent returns are strongly linked to the US economy in general, and the technology sector in particular. Sounds like a concentrated bet, doesn’t it?

The Dominant Country and Sector Factors

To identify the driving forces behind the outperformance of the MSCI World, our proxy of developed equity markets, we examine the selected domestic market indices (USA, JPN, AUS, GBR, FRA, GER, ITA) and global sectors using three criteria: relative performance, rolling return correlations (250 days) and valuations.

From a relative performance perspective, Japan comes in top of the class (in USD terms) followed by the US, France and Germany (see Figure 2). All four country indices also beat the MSCI World. Digging deeper into how the MSCI World behaves relative to its domestic constituents by means of pairwise correlations (see Figure 3), the US market proves to be most intertwined with the global index by far (correlation ? 80%). On the other side of the spectrum, the Asian/Pacific markets offer the highest diversification potential (20% ? correlation ? 50%). European markets lie somewhere in-between (50% ? correlation ? 90%). The price-to-book book ratio (see Figure 4) further shows the US market is (1) most expensive among all selected country indices, (2) is valued at levels not seen for more than a decade relative to the MSCI World, and (3) the only country index with a multiple above the benchmark, a very rare divergence. Hence, the US stock market appears to be the gravitational center of the MSCI World in terms of diversification (or the lack thereof), valuations and performance alike. By contrast, the Japanese, French and German stock markets offer a most particular setup: comparable above-average returns; however, better diversified and more reasonably valued.

Keeping this in mind, we move on to a sector comparison of developed market equities (see Figure 5). And a familiar pattern emerges. Similar to emerging markets, the technology sector is by far the best performing sector. Despite a slightly better diversification potential than industrial or financials (correlation > 90%), the technology sector is still strongly intertwined with the MSCI World featuring a typical pairwise correlation between 70% and 90% (see Figure 6). Consumer staples, energy and real estate display a much lower and more volatile co-movement by comparison (40% ? correlation ? 80%). From a valuation perspective, too, the technology sector is among the most expensive ones (see Figure 8). So, the technology sector stands out in terms of performance, concentration and valuation risks.

Hence, there are two elephants in the room: the US stock market and the technology sector.

Five US Technology Companies Dominate Country and Global Equity Performance

Our next step is to triangulate the extent of overlap between the US stock market and the global technology sector. Given the almost mythical reputation of « Silicon Valley », one may speculate the US dominates the technology sector. Measured against our proxies for performance, diversification and valuations, the US indeed appears to single-handedly represent the entire developed market technology sector. Global benchmark performance barely deviates from its US constituent over a 5-year window (see Figure 9), the average historical rolling pairwise correlation exceeds 95% (see Figure 10) and the price-to-book ratio of the respective domestic and global technology sectors move in lockstep (see Figure 11). Moreover, we document a tremendous intersection between the top 10 holdings of the MSCI World, MSCI USA and MSCI Technology indices (see Table 1) where five stocks (Alphabet, Amazon, Apple, Facebook, Microsoft) jointly account for a minimum of 5-10% of market capitalization. Remember the supposedly well diversified MSCI World and MSCI USA benchmarks have 1,648 and 625 constituents, respectively. Hence, the stock performance of developed markets today has turned into a concentrated bet on Silicon Valley’s ability to produce returns.

Fortunately, investors are not limited to remain within the boundaries of the global indices. The developed market technology sector for instance offers plenty of regional diversification potential (revisit Figures 9, 10, 11). Although liquidity constraints may present an issue at times, the potential gains from diversification seem worth the effort. Both the French or Japanese technology sectors offer similar or higher performance at lower correlations and valuations than their US equivalent.

US Technology Diverges from ‘Real’ Economy

The preceding analysis also helps to shed light on whether developed equity markets diverge from the real economy. When just five major technology companies jointly account for an outsized share of market capitalization of otherwise well diversified benchmarks (e.g. the MSCI World or MSCI USA), it is hardly surprising dislocations could occur. Using the USA as an example, Figure 12 indicates stocks may have indeed decoupled from industrial production, a proxy for real economic activity, in 2015. At the same time, the US technology sector diverged even more as the real economy could not keep up with rapidly growing service startups. But as the stock market moves further away from underlying economic fundamentals the question becomes if the real economy will catch up with reality or stocks catch down?

Global Stock Markets: A Concentrated Speculation on US Technology Stocks

Just five US technology stocks increasingly dominate the MSCI USA country index, and by extension the MSCI World equity benchmark, in terms of performance, concentration and lofty valuations. One important implication is that regional and sectoral diversification is much diminished at the same time. Prudent investors may therefore wish to take single positions in selected countries or sectors outside the respective aggregate indices to enhance diversification. Moreover, we detect a divergence between economic fundamentals as measured by US industrial production and the country’s stock market and technology sector. This adds a valuation risk to the concentration issue.

Figure 1: Performance of Global Benchmark (MSCI ACWI) vs. the Developed (MSCI World) and Emerging Market Peers (MSCI Emerging)

Figure 2: Performance of Developed Market Benchmark (MSCI World) vs. Selected Domestic Peers

Figure 3: Pairwise 250-Day Return Correlations of the MSCI World vs. Selected Country Indices

Figure 4: Price-to-Book Valuation Metric of the MSCI World and Selected Country Indices

Figure 5: Performance of Selected Emerging Stock Markets

Figure 6: Pairwise 250-Day Return Correlations of the MSCI World vs. Selected Sector Indices

Figure 7: Pairwise 250-Day Return Correlations of the MSCI World and the Technology and Materials Sectors

Figure 8: Price-to-Book Valuation Metric of the MSCI World and Selected Sector Indices

Figure 9: Performance of the MSCI Emerging Materials Index and Selected Emerging Stock Markets

Figure 10: Global Composite PMI and the Performance of Selected MSCI Emerging Sector Indices

Figure 11: Performance of the MSCI Emerging Technology Index and Selected Emerging Stock Markets

Figure 12: US Industrial Production vs Performance of MSCI USA and MSCI USA Technology

Table 1: Top 10 Holdings of the MSCI World, MSCI World Technology and MSCI USA

Published on Riskelia’s Blog