Friday's Market Minute: Is The Broad Index Relative Underperformance Really A Cause For Concern?

Equity markets are higher so far during the holiday-shortened week, even though labor market data showed a robust ADP private sector job report and another low jobless claims print. Overall, markets seem pleased that unit labor costs remain well-anchored for now and that the FOMC is likely to hold rates steady in June. Tighter financial conditions have not yet materially impacted consumers’ buying power despite persistent concerns about the potential for a recession and inflation that may remain inflexible for quite some time.

With year-to-date bullish trends in technology stocks while the broad index continues to underperform, investors may not ultimately accept the health of the stock market as a reality unless the broad market movement can be compared to what's occurring in the Nasdaq.

Investors are still not convinced that the recent big technology stock movement is sustainable due to the consideration of narrow market performance as an ominous sign of an unsustainable rally. One narrative supporting the case for a pending market correction is that tech stocks are moving in positive correlation with higher interest rates.

The opposite traditionally holds true, especially when one compares the 2020 tech rally that was clearly supported by rock-bottom rates, quantitative easing, and abundant fiscal spending. Since one definition of a growth stock can be recognized with cash flows that are far in the future, a lower discount rate increases their value disproportionately – whereas higher rates for longer may reduce the present value of those future cash flows.

A bullish narrative is supported by ubiquitous deployment of artificial intelligence as a renaissance-like secular growth story built around what is supposed to be the peaking of the current economic cycle. However, not all AI-based companies are moving higher in conjunction with big tech names like Nvidia NVDA and Microsoft MSFT.

With interest rates at high levels and the prospects of more rate hikes to come as the year progresses, if big tech names continue to run higher the narrative may shift to the strong cash flow-defensive nature of their businesses. Mega cap stocks simply don’t appear out of thin air.

They manifest over time as winner-take-all business with market share power that presents a solid value proposition rather than another short-lived speculative bubble. The unique business attributes of the half-dozen or so highlighted mega-cap tech companies place them in a league of their own. Therefore, perhaps the relative outperformance of the heavy weights should not be a surprise to see after all.

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