Author: Adam Phillips
Less than six months removed from its historic decline in March, as of the writing of this blog, the S&P 500 has rebounded more than 55%.
Although certainly better than the alternative, many investors continue to have difficulty reconciling the stock market’s recent performance with the day-to-day realities the nation is facing. To be sure, most would not consider an unemployment rate above 10%, the polarized political climate or ongoing protests around the U.S. to be ideal conditions for the stock market.
However, rather than ask why the stock market continues to go up, we might be better off asking ourselves if our current measure of market performance is providing an accurate assessment of the broad health of the market.
For years, investment professionals have considered the S&P 500 to be among the best benchmarks for measuring the performance of the large cap U.S. equity market (and far superior to the Dow Jones Industrial Average which only includes 30 holdings). However, no index is perfect, and this year’s performance has exposed the shortcomings of capitalization-weighted indices like the S&P 500, where member weightings are based on the size of the underlying company.
The performance among major technology companies has been well-documented over the last several months, and for good reason. Businesses like Amazon and Microsoft have been clear beneficiaries of this year’s pandemic and have seen their stocks rise nearly 90% and 45%, respectively, on a year-to-date basis. Meanwhile, Apple recently became the first stock in the U.S. to reach a $2 trillion valuation and is now worth nearly as much as all 2,000 companies in the Russell 2000 small cap index combined.
As a result of this relative outperformance, the underlying composition of the S&P 500 looks quite a bit different than it did ten years ago. In fact, the five largest companies in the S&P 500 (Apple, Microsoft, Amazon, Facebook, Alphabet) now account for roughly 25% of the index, more than twice as much as in 2010. Although these are great companies, one must wonder if a basket that assigns one-quarter of its value to just five stocks represents an adequately diversified portfolio.
For those struggling to understand the market’s strength these last few months, the takeaway here is that broad market gains have been driven by a minority of S&P 500 companies. In fact, even though nearly 30% of the members in the Index had recovered to within 5% of their 52-week high at the end of August, roughly 40% of constituents remained more than 20% away from this level (i.e. in a bear market).
There are different ways to interpret the wide dispersion in performance among U.S. stocks this year. On one hand, narrow market breadth can often hinder future market gains, so it will be important to monitor whether recent laggards begin to participate in the rally going forward.
On the other hand, one can argue that the fact that the market is differentiating between winners and losers of the pandemic suggests that investors are still focusing on individual security selection rather than going blindly into the stock market.
Although we maintain a favorable long-term view on equities, we acknowledge that different environments bring opportunities for some companies while creating risks for others. Since today’s laggards may be tomorrow’s leaders, we will remain committed to our focus on security and sector selection as we manage client portfolios in the months ahead.
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