Bob Homan: When share prices lose their focus
This column was originally written in Dutch. This is an English translation.
By Bob Homan, Head of the ING Investment Office
Which is better: a stock market driven by a handful of winners, or one in which almost everything is rising? The answer is less obvious than many investors think.
For years, investors complained that the stock market was becoming increasingly dependent on a small group of shares. A handful of US technology companies accounted for a large proportion of the returns, whilst many other firms lagged behind. This trend fuelled concerns about what is known as concentration risk. What if the results of a few heavyweights disappoint? Or if the enthusiasm surrounding AI wanes? Then the entire stock market might well collapse like a house of cards.
From concentration risk to broad-based optimism
In recent months, however, that picture has begun to shift. The rise in the stock markets is being driven by an increasingly broad group of companies. Financial institutions, industrial firms and parts of the commodities and energy sectors are also playing a significant part in this upward trend. Many investors see this as a healthy sign. After all, a market supported by more companies is considered more robust and less vulnerable to setbacks than one supported by a small group of heavyweights.
That sounds logical, but as is so often the case with investing, there is another way of looking at it. Just six months ago, I wrote about the exceptionally wide variations in share price performance. This so-called dispersion was at historically high levels. Some companies were labelled by investors as the winners of tomorrow, whilst other firms with comparable profit prospects were, in fact, punished. The AI narrative, in particular, led to significant differences in valuation and returns.
Are investors becoming less discerning?
That wide dispersion made it harder for investors to make the right choices, but it also had a positive side. It showed that market participants were being discerning, analysing fundamental differences between companies, and making a clear distinction between opportunities and risks. In other words: the market was actively considering which companies could actually live up to their high expectations.
Now that these differences are narrowing, the question is whether this is entirely good news. When more and more shares rise at the same time, investors often become less discerning in distinguishing between winners and losers. Risks are more easily overlooked when sentiment is positive.
When risk becomes cheaper…
We also see this diminishing urge to distinguish between companies reflected in the return investors demand for taking on risk. Periods in which virtually everything rises are often accompanied by a fall in the risk premium. We are seeing this at the moment too. Despite strong earnings growth, the equity risk premium is at its lowest level since the start of this century. This is linked to the sharp rise in interest rates, which has made shares relatively less attractive.
A lower risk premium means that investors are prepared to pay a higher price for the same future profit. This feels comfortable as long as the market is rising, but it also reduces the margin of safety.
…the power of diversification diminishes
There is another factor to consider. Diversification derives its strength precisely from differences in behaviour between investments. When valuations rise across the board and more and more shares move in the same direction, the protective effect of diversification diminishes. At first glance, this makes the market appear more stable, but beneath the surface, a new vulnerability may in fact be emerging.
That does not mean that a broader share rally is, by definition, unfavourable. On the contrary, it is a healthy sign when economic growth and earnings growth are driven by a wider range of sectors. However, investors would be wise to look beyond the surface. Ultimately, the key question is not how many shares are rising, but why they are rising. Only the answer to that question reveals the market’s true strength.