Dislocation Remains a Frustrating Theme for Financial Markets

The financial markets continue to grapple with a stark dislocation. The benchmark S&P 500 has rallied nearly 20% year to date, driven by a handful of technology giants, while the average and median stocks in the index lag significantly. This concentrated performance is even more pronounced in the Nasdaq 100 Index, up almost 45% this year, compared to the modest gains of the Russell 2000 (up about 5%) and the Dow Jones Industrials (up about 9%).

The Hope for a Broader Market Recovery

Much of this year’s economic resilience carried the expectation that the recovery would extend from dominant tech leaders to smaller-cap stocks and other economically sensitive sectors. However, despite a year-end rally fueled by hopes of lower interest rates and a soft landing, the disparity between tech’s dominance and the rest of the market persists. This highlights a significant dislocation between the over-owned tech giants and the neglected stocks across other indices.

Why the Dislocation Persists

A soft landing should, in theory, lift all boats, but the market continues to favor a few large-cap tech shares. While this concentration in tech isn’t necessarily irrational, historical patterns suggest such imbalances rarely sustain. The absence of a rotation into lagging sectors underscores skepticism about the broader economic resilience and the viability of a soft-landing narrative.

Systemic Risks Heading Into 2024

The persistence of this dislocation suggests the safety trade into big tech reflects growing concerns about systemic risk. Earlier this year, consensus forecasts predicted a 2023 recession, driven by the lagged effects of interest rate hikes, with recovery anticipated in late 2024. However, unexpected fiscal stimulus and liquidity injections from the U.S. Treasury and Federal Reserve offset these tightening measures, averting recession but selectively benefiting markets.

Fiscal Profligacy and Market Narrowness

While Treasury markets have shown improvement, term premiums still highlight fiscal concerns. The equity market’s narrow performance suggests that fiscal largesse is not trickling into the broader economy. Instead, smaller stocks and many industries remain sidelined, reflecting skepticism about the sustainability of fiscal-driven economic support.

The Role of Short-Term Funding Pools

The government’s fiscal borrowing in 2023 primarily drew from excess funds in money markets, which have declined from $2.5 trillion to about $800 billion. If these funds are fully depleted, the Treasury may need to source financing from longer-duration money pools or private sector reserves. This risk of “crowding out” private sector investments could exacerbate the equity market’s dislocation.

The Importance of Financial Plumbing

While the drain on short-term funding poses risks, monetary authorities typically step in to maintain financial stability at all costs. Quantitative Easing (QE) serves as the primary tool for this, underwriting fiscal debt servicing and providing liquidity for refinancing private debts.

The Consequences of QE and Policy Distortions

While QE tends to lift financial assets, the gains are often driven by monetary inflation, reducing real returns. This inflation remains confined to asset markets, failing to benefit the broader economy. The ongoing dislocation between big tech and the rest of the market highlights the distortion created by such policies, leaving most sectors outside of tech struggling to catch up.