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Investors in the U.S. stock market are facing a dilemma. The market has been rising, led by giant technology and growth companies, and now investors are debating whether they should sell their shares or hold onto them.
According to data from BofA Global Research, a record $8.5 billion has poured into tech stocks recently. This has contributed to the rally in the tech-heavy Nasdaq 100 index, which has gained 33% in 2023. The broader S&P 500 index has also risen by 11.5% this year and is currently at a 10-month high.
However, some investors are expressing concerns. They point out that the market rally is quite narrow. In fact, the five largest stocks in the S&P 500 index now make up 24.7% of the index, which is a record high since 1972. If these stocks were to stumble, it could have a significant impact on the broader market.
Peter Tuz, the president of Chase Investment Counsel, raises an important question: Will the current momentum continue, or will things return to normal?
The excitement surrounding advances in artificial intelligence (AI) has been a major driving force behind the gains in large-cap stocks. Companies like Nvidia, which has seen its shares rise by about 170% this year, along with Apple and Microsoft, the two largest companies in the U.S. by market value, which have both climbed nearly 40%, are leading the way.
Jay Hatfield, the CEO of hedge fund InfraCap, is optimistic about the future of megacap stocks. He believes that the excitement over AI will continue to boost these stocks. Hatfield is particularly positive about companies like Nvidia, Microsoft, and Google’s parent company, Alphabet.
Recent data showed that job growth in the U.S. accelerated in May, which has boosted investors’ confidence in stocks. They are hopeful that the Federal Reserve will be able to control inflation without harming economic growth. As a result, the S&P 500 rose by 1.45%.
Megacap stocks have been dominating the market for most of the decade since the financial crisis. Betting against them has proven to be a risky strategy in 2023. Investors are holding more cash than usual, according to data from BofA, which some market observers believe could fuel the rally even further.
Strong momentum can often push stocks higher. However, technical analysis suggests that the Nasdaq 100 is overbought, which means it could be more vulnerable to sharp declines. Nevertheless, history has shown that the index managed to rally another 10% over three months when it was in a similar condition two years ago.
An example of a stock that has continued to climb despite substantial gains is Nvidia. Even after a 109% increase before its May 24 earnings report, the stock rose an additional 30% in the past week following the chipmaker’s optimistic sales forecast.
Kevin Mahn, the chief investment officer at Hennion & Walsh Asset Management, believes that the shares of Nvidia, which now have a high price-to-earnings ratio, have become expensive. He suggests that while he still likes the technology sector in the next two years, he now focuses more on valuations due to the significant rise in large-cap stocks. Mahn finds Microsoft shares attractive, thanks to the company’s strong cash flow and healthy dividend yield.
Some investors are becoming more cautious, citing factors such as rising valuations and the underperformance of the rest of the market compared to a small group of soaring stocks.
According to S&P Dow Jones Indices, the performance of just seven stocks, including Apple, Microsoft, Alphabet, Amazon, Nvidia, Meta Platforms,
and Tesla, accounted for all of the S&P 500’s total return through May 2023. Additionally, only 20.3% of S&P 500 stocks have outperformed the index on a rolling three-month basis, which is a record low in five decades, as reported by Ned Davis Research. Historically, such levels have preceded weaker performance for the broader market, with the S&P 500 rising by 4.4% over the next year compared to an average of 8.2% for all one-year periods.
David Kotok, the chief investment officer at Cumberland Advisors, recently reduced his holdings in the iShares semiconductor ETF due to the surge in Nvidia shares. Kotok sees the narrowing breadth in the market as a concerning sign, and he also believes that equities are less favorable based on certain valuation metrics.
One widely used valuation metric, the price-to-forward earnings estimate, shows that the S&P 500 is currently trading at 18.5 times its historical average of 15.6 times, according to Refinitiv Datastream.
While market concentration can persist for some time, the narrowing of the market raises cautionary flags for some investors.