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The major indices may have only posted small gains on Wednesday, but while the generals were sleeping, the soldiers were on the march.
At the forefront, moderate losses in the large-cap energy and financial sectors were offset by outsized gains in the consumer discretionary sector, thanks primarily to Amazon (AMZN) and Tesla (TSLA).
This back-and-forth theme has become a subtle but important market narrative. On days when AI is not leading the charge, pockets of strength keep the S&P 500 from falling more sharply, which in turn keeps the index's volatility near multi-year lows.
The recent fall of Nvidia is illustrative.
On Monday alone, the AI โโmodel closed down 13% from its all-time high. Scanning social media, you'd think Wall Street was on fire.
But during that harrowing three-day decline, something curious happened: the Dow Jones Industrial Average (^DJI) (up only 3% this year versus 14% for the S&P 500) staged a recovery. Energy perked up and biotech jumped as forgotten parts of the market showed signs of life.
This offsetting behavior is everywhere right now rather than correlations between peer stocks in similar sectors. Stocks just don't want to move in the same direction.
"This is a generationally strange American stock market," Luke Kawa wrote.former director of investment solutions at UBS Asset Management Americas and now at Sherwood Media.
Kawa was referring specifically to Tuesday's price action, in which the S&P 500 eked out a 0.4% gain despite 384 of its constituents closing in the red, a new feat for a data set that goes back to 1996.
Recently, similar "firsts" have appeared in market statistics.
But none of this detracts from the argument (backed by extensive research and history) that it's perfectly normal in a bull market to have gains concentrated in a few stocks.
Winning stocks enjoying a secular-themed rally get bigger and bigger until the move runs its course.
In a bull market, when leading stocks falter, other parts of the market that may not be generating hype-filled headlines may rise to the occasion. Sector rotation keeps index-level volatility low as new winners offset losers. And then, at some point, the music stops and all sectors start selling off in unison, starting a new bear market.
Kawa related this to the current market, writing that "Different major groups within the US stock market have been marching to the beat of their own drum recently, and this dynamic has helped prevent the stock market from lurching violently lower."
We are currently not only seeing disparate returns across sectors and industries, but also within them, even in mega-cap tech stocks. In the last six months, if some of them, like Microsoft and Alphabet, go up, Nvidia and Apple could go down. The correlation between directional movements between pairs in this cohort is just 43%, Kawa said.
All this zigzagging keeps volatility at bay at the index level, but Kawa presents The main risk in this environment: a "correlated shock" that is distributed "among these companies that control a large part of the US and global stock indices."
Although the "big drop" remains the central risk, divergences may persist longer than arbitrage investors can remain solvent (to convert a old wall street trope).
In fact, research by BofA's data analytics team suggests that the current regime of low inter- and intra-sector correlation may persist for years.
"The multiple years of decorrelation in the 1990s as the Internet bubble developed suggest that the persistence of the current regime remains a risk," BofA wrote.
Consequently, the huge bifurcation in returns between the AI โโchosen few and the rest of the market need not end with a bang.
"Just because we're in uncharted waters doesn't mean we're heading toward a waterfall. It could end up being a lazy river." wrote coffee.
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