Fu Peng: A systematic review of the "chicken dinner shrinkage" in the US stock market in recent years

As the epidemic began, changes in different interest rates and economic environments have led the US stock market to undergo a large-scale "chicken shrinking" process. In today's diary, I will systematically review: In the second half of 2021, the market shifted from denominator dominance (assets like Cathie Wood's ARKK) to numerator dominance (large tech companies FAANG). The first wave of overcrowding in 2022 brought high volatility, with growth focusing on AI artificial intelligence. In 2023, the market continued to shrink from numerator dominance to top companies and a few assets, concentrating under low volatility. Once the environment changes and shrinks, volatility begins to increase.

Still analyzing from the perspective of numerator, denominator, and g

Based on the framework we previously constructed, the performance of the stock market is the result of the interaction of multiple factors. Specifically, this framework covers the three core elements of stock market performance, which can be metaphorically likened to the architecture of numerator, denominator, and g. This framework is widely applicable, not only adept in analyzing the US market but also demonstrating its powerful explanatory power in analyzing the Chinese market. I have shared the application of this framework in the Chinese market many times before, and today, we will focus on the US market again, examining its performance in recent years through this framework.

In the early stages of the epidemic, the US adopted extremely loose fiscal and monetary policies to support the economy, leading to record-low interest rates. This policy not only boosted market sentiment but also drove the continuous rise of the US stock market since 2020, with valuations repeatedly hitting new highs, even approaching the historical highs of the 2000 Internet bubble period.

During this process, companies that lacked solid performance foundations and relied solely on speculative concepts stood out prominently. These companies are similar to speculative targets in a primary market bubble, with Cathie Wood's investment portfolio being a vivid example: she focuses on so-called disruptive innovation and high-risk assets like ARKK. Her core investment philosophy fundamentally shapes the performance of ARKK in the secondary market, making it more akin to the investment characteristics of the primary market. These companies generally face significant valuation bubbles, with their stock prices often lacking solid fundamental support, and their value highly dependent on valuation levels and sensitivity to changes in risk-free and real interest rates. It is based on this that I frequently observe and analyze Cathie Wood as an important pure valuation asset target in my personal records Further observation reveals that this speculative frenzy has spread to multiple areas, covering not only GameStop Game Station with "Roaring Kitty" as a typical example, Robinhood and other similar assets, but also involving cryptocurrencies such as Bitcoin. These assets fundamentally exhibit similar denominator attributes, with common characteristics of high volatility and high risk, bringing significant uncertainty to the market.

Interest Rates and the Economy Begin to Recover from the Pandemic

With the fiscal policy inertia after the pandemic, as well as the continued fermentation of international division of labor and geopolitics before and after the pandemic, the U.S. economy has shown rare resilience, with the feedback of sustained employment wages driving the underlying inflation higher, while occasional supply shocks have also led to commodity inflation. As the economic recovery process post-pandemic progresses, inflation pressures intensify. Starting in 2021, the U.S. has continued to raise interest rates, leading to a continuous rise in interest rate levels, gradual narrowing of interest rate differentials, and an inversion where long-term rates are lower than short-term rates. At the same time, risk-free rates have also significantly increased.

This series of economic and interest rate changes have had a profound impact on the stock market. The U.S. stock market is in a strong background in both the numerator and denominator - that is, the numerator part (corporate profits or market growth potential) is showing a positive trend, while the denominator part (market risk-free rates or real rates) has also seen a significant increase. This has prompted a structural transformation in the U.S. stock market: on one hand, the numerator will strongly support assets in the stock market with growth potential and value; on the other hand, the denominator will exert significant pressure on assets that are completely dependent on future expectations, with valuations in a bubble, and may even directly burst these bubbles.

In the chart analysis, I still selected the representative ARK as the observation object. As we entered early 2021, with the gradual implementation of rate hikes by the Federal Reserve, the rise in real interest rates began to erode the foundation of these bubble assets. With the reversal of the interest rate environment, these bubble assets began to burst, and the market gradually returned to a more rational state.

It is worth noting that large tech companies are not entirely equivalent to typical tech bubbles or disruptive innovation bubbles. These large tech companies have both huge cash flows and robust development and defense strategies, as well as the ability to invest in capital expenditures, technological innovation, and future growth. Their financing channels are completely different from small companies, and changes in risk-free rates will not even squeeze their financing. Moreover, these large tech companies also have huge cash reserves, making them the optimal safe investment choice at this stage. The rise in interest rates will not only not squeeze their valuations, but will even help large tech companies squeeze out small innovative investment companies (small companies dependent on financing), and they can use their huge funds and better financing channels to acquire these startups with technological and growth capabilities Allowing oneself to also benefit from technological growth;

Therefore, capital flow becomes the focus of the market: the first wave, similar to Cathie Wood's ARKK, the bursting of asset bubbles driven by pure denominator valuation will accelerate the influx of funds into some stronger assets that can act defensively. At this time, you will find that FAANG was the best asset choice at that time. Of course, even the best assets will adjust their investment strategies with the influx of a large amount of funds (shrinking the circle), pushing up their valuations, manifested as a significant increase in P/E (I usually use Schiller's CAPE RATIO). However, at this time, the market's extremely low volatility will appear, starting to form a feedback loop where the more concentrated, the lower the volatility, and the lower the volatility, the more concentrated;

With the further rise in interest rates in the short term (interest rate curve shifting from contango to back), this is not just a matter of capital flow, but more of a process of shrinking and eliminating investment targets. The U.S. stock market is also significantly affected, as even core asset groups are experiencing overvaluation due to style shifts. When the market as a whole reaches a certain high level (such as the 33 to 34 range), volatility amplification can occur at any time;

The entire market's assets experienced a profound adjustment in 2022, during which the suppression effect of the denominator end (i.e., risk-free interest rates and real interest rates) widely permeated various types of assets: from ARKK funds that purely rely on the denominator effect (pure denominator assets were hit the hardest), to even FAANG giants with molecular end support, none were spared. The previous influx of funds leading to denominator expansion has caused the pressure on the denominator end to exceed the market's original expectations.

The overall market volatility remains high, maintaining a high volatility trend, gradually achieving market self-purification through valuation adjustments and reduced leverage within the market, until core assets experience a deep adjustment and gradually fall back to a more reasonable valuation range of 26 to 27.

Friday's Actions by the Federal Reserve

After the market stabilizes, its characteristics align with the new economic and interest rate environment, showing a delicate balance of market risk appetite that is neither fully expanding nor fully contracting. This means that the market has not fully shifted towards a risk expansion (such as promoting assets like ARKK or GME again), but rather shows that core assets (especially large tech companies) dominate in economic growth, having more capital advantages to invest in capital expenditures and innovation, and their valuations become relatively acceptable in the interest rate environment. In comparison, small companies face many challenges in financing and expansion, leading to a more significant trend of the strong getting stronger and the weak getting weaker in the market.

Therefore, in the new low volatility, high interest rate environment that started at the end of 2022, investment portfolios that rely entirely on specific strategies like ARKK are finding it difficult to attract market attention. This is also what I mentioned before, if the high interest rate environment (nominal and real) does not return to the past in the long term, ARKK funds may be excluded from the market mainstream for a long time In this environment, on the one hand, cash cow assets are still favored by the market, including investors like Babite, etc. On the other hand, since the end of 2023, the market focus has gradually shifted to new AI technologies such as ChatGPT, and the expectations for artificial intelligence have started to rise significantly. These large tech companies have regained growth expectations in a balanced (interest rates and economic) environment (at this time, the game of "Gold Rush Town" begins), and the game enters a process of further narrowing down core assets (among large tech companies), from SP100 to three companies and then to NVDA alone. The game still repeats the process of "chicken dinner shrinkage":

" It seems that the volatility is getting lower, the leverage of on-exchange bets is getting higher, the concentration is getting higher, and the growth expectations represented by these large tech companies are also driving the overall market valuation expansion. The Schiller CAPE RATIO has climbed above 35 again, but don't forget that this valuation expansion is happening against the backdrop of current risk-free rates exceeding 5.5%, not the previous negative real interest rate environment. So, this means that all valuation cores will shift to the expectations on the numerator side, simply put, only when these growth prospects really turn into performance (that is, selling out shovels to dig out gold) can they maintain stability in this low volatility environment. Any miss will bring volatility impact; "

Scenario One: If the growth of the numerator (micro AI industry) falls short of expectations, the impact of excessive leverage, the fading of the top company effect in volatility, the market becomes more balanced, while the value of the numerator remains (at the macroeconomic level), the market gradually transitions to low volatility oscillations to digest valuations until new numerator growth (micro AI industry) breaks through again;

Scenario Two: If the growth of the numerator (micro AI industry) falls short of expectations, the impact of excessive leverage, the fading of the top company effect in volatility, and at the same time, the value of the numerator falls short of expectations (at the macroeconomic level), then the overall market volatility cannot be reduced, similar to the second half of 2022, half a year of high volatility causing the market to decline to clear valuations, the cape ratio digesting through stock price declines, of course, under this assumption, the risk-free rate may decrease, and the numerator and denominator find a new balance at a new valuation level (below 30X)