“The S&P 500’s Metamorphosis”

Montreal, April 29, 2020

Franz Kafka’s novel The Metamorphosis is about a travelling salesman who wakes up one day inexplicably transformed into a large insect. An analogy can be drawn between Kafka’s travelling salesman and the S&P 500 Index, which is turning into the often-mocked Nasdaq 100 Index. In fact, with the ongoing outperformance of large capitalization stocks in the technology and related sectors, the five largest constituents in the S&P 500 Index – Microsoft, Amazon, Alphabet, Apple and Facebook – now represent nearly 22% of the overall index. This is the most concentrated that the S&P 500 Index has been since the dot.com era. Interestingly, in contrast to 20 years or so ago, the five largest constituents of the S&P 500 Index are the same as the five largest constituents in the Nasdaq 100 Index. The only difference is that the five largest constituents comprise 44% of the Nasdaq 100 Index. While the degree of concentration is higher in the Nasdaq 100 Index than it is in the S&P 500 Index, similarities are becoming hard to dismiss. What this means is that the S&P 500 Index is getting more closely related to an index which is portrayed as a poor representation of the United States stock market due to its excessive sector or single stock concentration and its looser profitability criteria for inclusion. Nevertheless, if the Nasdaq 100 Index is seldom accepted as an adequate benchmark for those reasons, how long will it take before investors question the appropriateness of the S&P 500 Index for benchmarking purposes when such an index is itself becoming, keeping with Kafka’s sudden metamorphosis theme… buggy?

While we are not suggesting that the lack of market breadth is synonymous with an imminent market crash, strictly for risk management purposes, we would conjecture that the proportion of the top five S&P 500 Index constituents will not get much higher before alternative benchmarks are considered by both institutional and individual investors. It would not be the first time that such considerations take place. In Canada for instance, subsequent to the fall from grace of Nortel in 2002, which represented over 30% of the index at its peak, S&P has been maintaining its S&P TSX Capped Composite in 2002, limiting the weight of any constituent to 10%. If that happens for the S&P 500 Index, the most widely tracked equity index in the Western hemisphere, it could have deep implications on performance outcomes for various investment strategies which have intentionally or accidentally been benefitting from the ever-increasing concentration of capital in the largest S&P 500 Index constituents. To this point, growth, momentum, and even low volatility strategies – which ironically often overweight large capitalization technology stocks with low net debt and thus exhibit low market sensitivity – could see a reversal of fortune. Also, strategies that have been developed to consider environmental, social and governance (ESG) metrics and which have been performing well partly due to their structural underweight in industries such as mining and casinos, could also suffer should investors preferences change.

About Negative Oil Prices and Other Platitudes

Most market observers were stunned when interest rates turned negative in Europe a few years back. As time passed, we have come to accept negative rates as normal for the eurozone and not so much of an oddity in other parts of the developed world. On April 20th, another asset class experienced a similar fate for the first time in its history when the price for a barrel of West Texas Intermediate (WTI) crude oil delivered at Cushing, Oklahoma fell well below zero, to as low as -37.63$ per barrel for May futures. Crude oil implied price volatility skyrocketed to almost immeasurable and never seen levels.

This sudden, severe price drop is referred to technically as a “long squeeze”. It happened because financial participants, who comprise the majority of short-term futures long positioning in this market, have no intention to take physical delivery of the commodity upon contract expiry. As such, they must sell their contracts before expiry and buy new ones expiring later. This is what is called “rolling” positions. By some estimates[1], one exchange-traded fund (ETF) – United States Oil Fund LP (USO) – in particular, held as much as 25% of the long open interest in the May WTI contracts as of last week.

But since these operations take place on a monthly basis, why had this never happened before? In fact, there are normally commercial and industrial participants that stand prepared to take physical delivery. However, in the current environment, as demand for crude oil and refined products evaporates, excess supply has been accumulating and crude oil inventories are approaching their physical limits. While it is widely expected that OPEC+ will cut production by as much as 10 million barrels per day starting on May 1st and since the United States production has already declined by nearly 1 million barrels per day, evidence suggests that demand is waning faster and that inventories will inevitably continue to build, likely maxing out storage capacity in the coming weeks. With that in mind, we might very well witness another plunge when the June WTI futures expire. If it is premature to assume that negative oil prices fall in the realm of normalcy, we nevertheless expect the petroleum complex to remain under pressure and prices to remain volatile until a post-Covid-19 supply and demand equilibrium is found.

For the moment, we note that the stock price of oil producers did not fare much worse than the market as a whole on April 20th. Similarly, petro-currencies (including the Canadian dollar) did not weaken as much as the negative oil price headline would suggest. In other words, there is hope that this shock will be short-lived. This reaction, or lack thereof, reminds us of the unlikely hero in Kafka’s novel, whose first thought upon discovering his new appearance is to shrug it off as a bad dream and to try to fall asleep again…

Unfortunately, Kafka’s travelling salesman finds that his condition has not changed the next day. For those who think that increasingly politicized central banks are omnipotent, we are reminded that while central banks can be very effective facilitators, they cannot magically produce fuel-tank farms so that the crude oil oversupply vanishes. Similarly, central bankers cannot prevent rig count from falling, nor oil wells from being shut. They can neither coerce people to drive around their neighborhood without purpose to rekindle demand. To summarize, central banks have little control over commodities prices.

No Middle Ground

The Gross Domestic Product (GDP) in China collapsed by 6,8% during the first quarter. It was the largest decline since the end of the cultural revolution over 40 years ago. Without a doubt, for the developed world where the effects of the Covid-19 outbreak lag by roughly 6 weeks, the second-quarter GDP figures will be considerably worse.

Given the sheer magnitude of those declines from a historical perspective, coupled with the hidden risks that may percolate, we find unsettling the fact that global equity markets are down less than 20% from their mid-February peak. In fact, we see a growing rift between the “V-shaped” recovery (a quick return to the initial state) that the capital markets seem to imply and the “U-shaped” (a slow recovery) or “W-shaped” (a recovery with many ups and downs) recovery trajectories that economists foresee. At the moment, the “V-shaped” recovery camp is winning this tug-of-war, the logic being that for central banks, there is no middle ground between perpetuating an asset bubble and an economic depression. And as we’ve learned since the Great Financial Crisis (GFC) a little over a decade ago, for central banks, however absurd, the asset bubble is the lesser evil. At the moment, market observers seem comfortable with this.

Incidentally, the most troubling aspect of Kafka’s stories from a reader’s perspective is not the absurdity of the situation in which characters find themselves[2].  Instead, it is that they slowly accept it and become comfortable with it.

Dimitri Douaire, M. Sc., CFA
Co-Chief Investment Officer


[1] Bloomberg

[2] The Castle, The Trial

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