THE MYTH OF LARGE CAP LIQUIDITY
August 23, 1998
CONVENTIONAL WISDOM
It is the conventional wisdom that the largest capitalization stocks have the greatest market liquidity. They can be bought and sold in large blocks with ease and individual investors can also trade them easily. After all some of them have as many as 3 Billion shares outstanding, market valuations approaching 300 Billion Dollars, they are widely held and actively traded. In essence if you want to buy or sell these largest capitalization stocks it can be easily done. They are the cream of American business with names such as General Electric, Microsoft, Coca-Cola, Merck, Pfizer, Wal Mart and so forth. They also, for the most part, have enviable earnings and growth records. These are the stocks that are the darlings of the large cap funds and the growth funds. If you are a fund manager they can't fire you for buying them, they are big and beautiful especially if you must be fully invested all the time. These kinds of stocks have become the core holdings of the better preforming funds. These stocks are also the backbone of the S & P 500 index. G E and Coke alone are 5.7% of the this capitalization weighted index. As I have pointed out many times before the top 25 stocks in the S & P 500 equal 35% of the index and the top 50 stocks are 50% of the index. The S & P 500 is not a broad based index but rather a super large cap index.
FASHION AND FAD IN THE STOCK MARKET
At various timer in the past I have written about "fashion and fads" in the market. Various stocks or groups of stocks become all the rage of money managers and the investing public. We can all remember the Semiconductor and Hi-tek stocks and the SOX Index of two years ago. We are all aware of the Internet stocks now. When a group is in fashion everyone piles in. The stocks go up and then more investors pile in and they go even higher. As this happens the ownership of these stocks becomes more and more concentrated and their liquidity decreases and they become more price volatile. The same funds and investors keep buying the same stocks. This situation comes and goes and usually we relate it to a particular industry or market segment. There has been a fashion and fad in the market over the last year or two that has gone unnoticed by most investors. That is Indexing and also chasing of the large cap growth stocks by the better performing funds. There is no difference between this and piling on to one industry except that it is much much larger.
CONCENTRATION OF OWNERSHIP
As a stock market fashion progresses the liquidity of the stocks in the in fashion group declines dramatically. To maintain a liquid market there has to be a large floating supply of stock. There also has to be independent decision making as to whether to buy, sell or hold and at what price. As fashion stocks run up both are lost and decision making gives way to just the momentum of the moving stock. As liquidity declines prices become much more volatile. And so it goes on until a day of reality comes. When the game ends everyone wants to get out and all at the same time. Then the stocks collapse. Since ownership is more concentrated and decision making has been abandoned there are no buyers until the stock drops back to rational values.
This morning I checked the concentration of ownership of some of the largest cap stocks. As an example here are a few with the percentage owned by institutions and their P/E ratios, add to that number stock owned by founders and insiders and you can see the developing situation. GE 50.4% P/E 34.1, KO 50.5% P/E 51.2, PFE 57.4% P/E 56.1, MRK 54.8% P/E 32.2, MSFT 36.0% P/E 66.2, CSCO 67.2% P/E 81.5, WMT 38.5% P/E 37.3.
What has developed is an ownership concentration in some very large institutional holders along with high valuations. Often we think of institutions as strong holders. At these valuations I question how strong they really are. The super cap stocks are the core of the Index Funds and of some of the largest Growth Funds.
INVESTMENT DECISIONS
There is no investment decision for the manager when it comes to an Index fund. The public makes the decision. Since the fund must always represent the index when money comes in it is the largest cap stocks that are bought. When the public withdraws it is the largest cap stocks get the bulk of the selling. The large cap funds are a different story. They are super sensitive to earnings. We all know what happens when a company disappoints or even warns of an earnings disappointment in the future. The fund managers head for the door.
In the past when an industry index, such as the SOX for example, collapsed it was not a big deal for the market as a whole. The problem now is that the indexes for the super cap stocks are the DOW, the S & P 500 and the NASDAQ composite.
SELL TO WHO
The story goes that after the Hunt brothers cornered the Silver Market they called their broker and said that they wanted to take some profit. Sell some Silver they told the broker. The broker replied "sell to who?" That is an exaggeration of the present market situation. But the problem is the same. When ownership is concentrated and valuations are high liquidity disappears.
I have always been of the opinion that the public is smarter than Wall Street thinks they are. I also hold the opinion that the public does not like to loose money. It is my judgement that we are much closer to the public threshold of pain than most in the investment community think. It does not take a wholesale flight from the market to cause selling. Just a marginal withdrawal can start the ball rolling out of control because there is very limited liquidity in the super cap stocks and any decline in them is immediately reflected in the major indexes that the public watches.
Victor Weintraub, August 23, 1998
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