Just How Strong Is This Market?

Thoughts on the S&P rally. Plus: a drink maker suffers a COVID hangover and now looks cheap.

Welcome back to The Market Beat! After a short break for a routine knee surgery, the newsletter should resume something like a more normal schedule going forward. Cheers!

The Gorillas In The Room

With earnings season swirling around us, the Fed signaling that the interest rate hikes it has already implemented have likely yet to fully take hold in the economy, and a continuously squeezed U.S. consumer, folks are wondering, generally, why the market has performed so well despite the presence of these seemingly massive headwinds.

Year to date, the S&P 500 SPY 0.00%↑ has delivered 15% to investors. While it is true that the lion’s share of those gains came in the front half of 2023, the index has held up quite well in the back half, which indicates that investors are generally optimistic that at least the gains sustained earlier in the year (which is another way of saying the outlook for the market) are still warranted.

Accepting this conclusion, of course, seems a bit naive when you consider the fact that SPY is market-cap weighted, which means that the largest constituent stocks are responsible for an outsize portion of the movements of the index.

The Economist recently published an article about the ‘S&P 493’—or, the S&P 500 minus its seven largest constituent stocks: Amazon AMZN 0.00%↑, Apple AAPL 0.00%↑, Alphabet GOOG 0.00%↑ GOOGL 0.00%↑, Meta META 0.00%↑, Nvidia NVDA 0.00%↑, Tesla TSLA 0.00%↑, and Microsoft MSFT 0.00%↑.

After stripping out the so-called ‘magnificent seven,’ the performance of the index’s remaining stocks is suddenly a bit underwhelming. By my calculations via data from Koyfin, the magnificent seven have been responsible for a whopping 13.58% of the year to date gain in SPY, meaning that the remaining 493 stocks in the index have only generated 2.06% of the year to date return.

That’s… concerning.

It also allows us to examine the question of ‘is the market’s current rally sustainable?’, because what we’re really asking is whether or not the rally of these seven gorillas is sustainable. The other 493 stocks, it would seem, hardly matter.

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One Overreaction Leads To Another

Remember COVID? Seems like a lifetime ago, but it has been three years since the world was forced to sit at home with very little to do except, well, drink. Alcohol consumption during COVID lockdowns went up massively—the National Institute on Alcohol Abuse and Alcoholism estimates that sales of alcohol spiked in 2020 at a rate not seen in 50 years.

From a fully economic perspective, this was a boon for makers of alcoholic drinks, none more so than Diageo PLC DEO 0.00%↑, whose stock boomed from the $120s in 2020 to a high of $211 at the start of 2022.

The party, though, seems to be winding down. The stock is currently taking a big hit on the news that the company is forecasting weakening demand. In particular, the company is seeing a drop off in sales in its Latin American business, which accounts for roughly 11% of sales.

While the COVID story is the obvious near-term culprit for the stock’s rise, it’s unclear whether or not the stock’s fall makes complete sense at these levels.

Forward valuation metrics for the company show that Diageo is now tagging levels not seen since 2014.

What’s more, the admittedly crowded chart above (sorry) shows that the underlying business metrics have not wholly deteriorated over the last 10 years. Cash from operations (purple) and total revenues (orange) have remained relatively robust, while the company has repurchased 10% of the float (yellow).

This leads one to wonder whether or not the market has followed one overreaction with another, pushing the stock down on news that isn’t great but also isn’t life-threatening, while fundamentals remain relatively robust.

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Final Thoughts…

The world’s biggest bank is having to use USB sticks to conduct operations. Consumers are expecting more inflation than ever. Bankers are starting to dump their own stocks. Canada is investing $4 billion in green hydrogen projects. More thoughts on WeWork.