Concentration Risk

Concentration Risk

After a choppy first half of October, the global stock market rallied and ended the month up by 6%. Of the major categories of stocks, U.S. small caps were the winners, with an 11% increase in the Russell 2000 index. Bond investors were left out of this recovery, with the Bloomberg U.S. Aggregate Bond Index down about 1.3% during October.

Equity investors might be feeling a sense of déjà vu at this point, reluctant to grow too attached to the most recent recovery. Despite the overall U.S. stock market being down about 18% this year, there have been at least five significant rallies during 2022. For those hoping that the market would fully recover from this year’s losses before year-end, we caution that volatility is still very much with us. Inflation, for example, remains stubbornly high. The October data release showed a drop from 8.3% to 8.2%, but that drop was again too meager to satisfy the Federal Reserve. The Fed is widely expected to hike their policy interest rate by 0.75% on November 2nd, then by another 0.50% to 0.75% after their December meeting. While they are likely to pause further hikes some time in early 2023, they would probably need to see a significant reduction of inflation and/or a weakening of economic fundamentals to see an interest rate cut.

As with prior months, October presents its share of positive economic data. U.S. unemployment remains low at 3.5%, and new data shows the economy added 263,000 jobs in September. Additionally, an initial estimate of domestic GDP showed the economy returned to growth during the third quarter, growing at an annualized rate of 2.6%. But that data alone hasn’t been enough to lead the market into a full recovery. In our view, we would need to see a more significant reduction in inflation combined with resilient corporate profits for stocks to push to new highs before the end of the year. Since there isn’t much clarity on the future direction of profits or inflation right now, volatility will likely persist through the end of the year.

Clearer is the market’s lesson about the importance of diversification. Major technology companies such as Amazon, Google, Microsoft, and Facebook parent Meta reported disappointing quarterly results and fell by -7% to -24%.  On the days immediately following these unsatisfactory reports, the broader U.S. stock market was flat to positive. We find it remarkable that several of the largest companies in the world, constituting over 11% of the U.S. market, could decline in value so rapidly yet barely affect the broader U.S. market. This episode should serve as another reminder to investors about the dangers of concentrated stock bets: what was unnoticeable to the diversified investor was quite pronounced to the investor betting big on a few large technology stocks.

As we move into November, and as the holiday season begins, we look ahead with a thankful spirit. We wish you and your loved ones a peaceful and warm Thanksgiving. Should you need anything, don’t hesitate to contact us. We are here to help.

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