Change in the sectoral structure of the American stock market due to COVID-19 as an additional risk factor by Aleksei Kirilov & Valeriy Kirilov

change in the sectoral structure of the American stock market due to COVID-19 as an additional risk factor

by Aleksei Kirilov & Valeriy Kirilov

The events in the US stock market in the first half of 2020 provide a unique opportunity to study the dynamic characteristics of the market. This strong and sharp decline and subsequent highly uneven recovery provided a resilience test of risk management approaches for many investors and lenders. This article examines the dynamics of changes in sectoral structure of the stock market due to the COVID-19 pandemic. An understanding of the prospects for the development of a particular industry is necessary for both investors and lenders in order to correctly assess investment risk and risk of lending to a company from this industry. This article is to some extent a continuation of the study of the American stock market, which we began in [1] and [2]. Note that earlier we had predicted the market correction for March - April 2020, see [2]. But the pandemic has brought this correction closer and much stronger.

To compare the behavior of stocks of various companies, we used the dimensionless value of the relative weight of these companies in the S&P 500 index. To do this, we used the ratio of the company’s daily share price to the value of the S&P500 index. Then the results were normalized to the value of the company’s weight in the index, which was on February 19, 2020. This is the date of the maximum rise of the market before the fall. Thus, it is possible to analyze the change in the weight of the company in the index, i.e. compare the change in the capitalization of a given company with the behavior of the entire market. For calculations, the data of the service https://finance.yahoo.com were used from January 1, 2020 to September 30, 2020 inclusive.

Consider the dynamics of shares in consumer sector companies (FMCG) using the example of CL, KMB and PG. Fig. 1 shows the graphs of changes in the weight of these companies and there is also a graph of changes in the S&P 500.

The weight of all three companies in the index instantly began to rise when the market fell, i.e. investors almost immediately realized that the sales of these companies should grow in a pandemic. Therefore, the quotes of their shares fell much less than the market as a whole and their weight in the market capitalization increased significantly. The rate of growth is comparable to the rate of decline of the S&P 500. The change in the weight of stocks and the change in the S&P 500 occur in different directions, and with a fairly high correlation. Later, as the market recovers, the proportion of these shares in the index gradually decreases. However, as of the end of September, the weight of these companies is still slightly higher than before the market fell.

The situation is completely different for large banks such as BAC, USB and WFC, see Fig. 2. The weight of these banks’ shares in the index is almost constantly decreasing, both during a sharp decline in the market and during its recovery.

And in the end of September it is 20 - 30% below the initial value of February 19. Apparently investors are distrustful of the business prospects of these banks. In other words, investors believe that many of these banks’ borrowers will have problems.

Let’s look at the stocks of companies in the high-tech sector. We have chosen companies DOCU, NET and ZM, see Fig. 3. They are united by the fact that their services and products are created on their own cloud platforms.

The weights of these companies in the S&P 500 are almost constantly growing, both during a sharp decline in the market and during the recovery period. And by the end of September, more than double the baseline values before the market crash. This indicates that investors appreciate the prospects of their business.

We have considered several cases for companies from different industries. Based on these, it can be assumed that there is some regularity in the change in the sectoral structure of the American stock market. To identify this regularity, let’s consider the change in the capitalization of the entire market and its main sectors.

As the initial data, the values of capitalization of the main sectors of the American stock market from the Finviz were used: https://finviz.com.

Table 1 shows data on the capitalization of various sectors and the market as a whole in billions of US dollars from September 17, 2019 to September 30, 2020.

For further analysis, it will be more convenient to use the share of each sector relative to the total capitalization of the stock market, as shown in Table 2.

Figure 4 shows the results for February 19 and September 30, 2020. The sectors were divided into two groups. Four sectors have significantly decreased their share in the capitalization of the entire market: Financial, Basic Materials, Utilities and Industrial Goods. And the other four sectors, on the contrary, increased their share in the total market capitalization: Healthcare, Services, Consumer Goods and Technology.

Let’s now take a closer look at the dynamics of changes in the quantities under consideration. We will take the values of the capitalization of each sector as of February 19, 2020 as 100%, and calculate the corresponding values for other dates. Build a graph of changes in the relative capitalization of sectors that have lost their share in market capitalization: Basic Materials, Industrial Goods, Financial and Utilities, see Fig. 5.

Here is a graph of changes in the relative capitalization of the entire market also. At the initial stage of the fall, all four sectors declined more than the market or like the market. During the recovery phase, these sectors are growing noticeably slower than the market, i.e. their relative share is still decreasing.

Let’s look at the graph of changes in the relative capitalization of the “grown sectors”. These are the Consumer Goods, Healthcare, Services and Technology sectors, see Fig. 6.

The behavior of these sectors is the opposite of the “loser sectors”. Initially, they all fell less than the market. And during the recovery phase, everyone except Healthcare is growing faster than the market. This means that their relative share in the American stock market continues to grow.

Analysis of the data presented in this paper allows us to draw several conclusions. First, amid the collapse of quotations in February - March, most investors correctly assessed the potential of different market sectors and reacted quickly. Second, there is indeed a change in the sectoral structure in the stock market, but the scale of these changes can be finally assessed no earlier than one or two quarters after the economy returns to a “calm” state. Third, the COVID-19 pandemic appears to have only intensified and accelerated trends that had begun to form earlier. Apparently, the change in the sectoral structure of the stock market is due to the formation of a new economic order.

It should be noted that with such sharp market fluctuations due to a shock in the economy, the use of the P/E parameter is beside the purpose, since it can lead to a distorted assessment of the potential of a particular industry or stock. The matter is that the change in the P/E is caused not only by the degree of recovery in stock prices, but also to a sharp change in the earning of companies in the past period due to the lockdown. In such cases, it may be better to use the weight of a company’s stock or industry in the capitalization of the entire market.

A correct assessment of the potential of various market sectors, in our opinion, is extremely important for improving risk management approaches. In order to take into account the changing structure of the stock market, risk management units of banks and companies will have to review their investment policies, limit policies, including industry limits, asset and liability management, stress testing scenarios, internal credit rating models, and so on.

references

1. Aleksei Kirilov, Valeriy Kirilov. High business concentration as a source of strategic risk. Intelligent Risk (PRMIA), July 2019, https://issuu.com/prmia/docs/intelligent_risk_july_2019_issuu

2. Aleksei Kirilov, Valeriy Kirilov. US stock market: growth potential or risk of falling? Intelligent Risk (PRMIA), January 2020, https://issuu.com/prmia/docs/intelligent_risk_-_jan_2020_-_issuu

authors

Valeriy Kirilov

General manager at Conflate LLC

Conflate is a Russian management consulting company specialized in strategy, risk management, asset management and venture investment. Valeriy has 15+ years’ experience in risk management and management consulting (BDO, Technoserv, then at Conflate). Besides he previously worked in the nuclear power industry (safety of Nuclear Power Plants).

Valeriy has an MBA from London Metropolitan University as well as a financial degree from Moscow International Higher Business School MIRBIS and an engineering degree from Moscow Engineering Physics Institute. He holds the PRM and FRM certifications and the certificate of Federal Commission for Securities Market of series 1.0. Valeriy was a member of the Supervisory board of the Russian Risk Management Society in 2009 – 2010.

Aleksei Kirilov

Partner at Conflate LLC

As the partner of Conflate, Aleksei is responsible for asset management and venture investment. He specializes in the US stock and debt markets. Aleksei has more than 15 years of experience in financial services including development of financial strategy and financial KPI, liquidity management; controlling system, allocation of expense on business unit, financial modeling and debt finance. He has cross industries experience: banks, oil & gas manufacturing, real estate.

Aleksei has an MBA from Duke University (Fuqua School of Business), a financial degree from Russian Plekhanov Economic Academy and an engineering degree from Moscow Engineering Physics Institute.