FAANG Stocks and the Deflating Bubble

There are three elements: How crowded the nightclub is; how many exits there are; and how flammable the structure is.  Big crowds means more people pushing through the doors. Fewer exits means more time to get out. And more flammable means less time available to get out.

For the markets, crowding is concentration; the number of exits is liquidity, and the flammability is leverage. If you have concentration without liquidity, and leverage that forces people to exit the market, you have the set up for a leverage-liquidity cascade:

A price drop forces leveraged investors to sell quickly; there are not a lot of people out there ready to take the other side, so prices drop; with the price drop some possible buyers get cold feet and so the price has to drop more; which means more forced selling by the leveraged investors who have to sell. And so on. So you get a market crash.

The market has been concentrated, leveraged, and illiquid. But there are some signs things are easing up. One simple way to see this is the recent rotation shown in this chart. There is a move from tech and financials toward more defensive sectors.

Another way is to go down the list of what is happening with concentration, leverage, and liquidity.  And, I’ll add another to that: valuation. That is, are prices overstretched relative to fundamentals. Maybe there is a way to add that to the nightclub analogy, but I haven’t figured it out yet.

Concentration: The percent of S&P 500 market cap in the top ten stocks has dropped from over 30% — its highest in over 40 years — to under 28%. Still not great, but, again, a slow leak.

Leverage: Margin debt as a percent of GDP is down from 4.0 to 3.2. Sounds good, except the 4.0 was an all-time high, and the current level is still higher than any time before 2020. And the cost of leverage is rising with rates.

Another leverage measure doesn’t look that great, namely the percent of household financial assets held is equities. It remains at an all time high. This is not strictly speaking a leverage measure, but it serves the purpose because it gives a sense of how far households are over their skis. If things turn, they will need to sell to get onto a more even footing.

Liquidity: I’ve left liquidity for last because there is no clear cut measure for it. The reason is that liquidity usually seems fine when we are dealing with the day-to-day buying and selling. The measure of poor liquidity is what happens when everyone is rushing for the exit all at once. And it is hard to know that before it happens.

One way to look at liquidity is indirect. How many people are there in the nightclub — that is, concentration. How flammable things are, which is a way to think of the effect of leverage. Or ask who is left to be a liquidity supplier. Another way is to look at the macro level, the money supply available after it is used for non-financial functions. This is higher than it was last year, but is still below any time pre-2020.

The Fed can pump liquidity into the market, which they did to a heroic level in March of 2022. But don’t bet on that — at least if you are in risk management mode, you don’t want to cross your fingers and hope for a rescue. The markets were on the brink of failure then. I doubt the Fed will intervene in the face of a typical market downturn.

Valuation: The P/E ratio for technology stocks has dropped from a high of 28 in December to 22 today. (Really, depending how you define technology, it can be in the 30's, but still, it is down from its peak.)