America’s tech giants have been dominating the price performance of the S&P 500 lately. However, with a closer look at how the S&P 500 is constructed, insights as to why the seeming disconnect between the economy and the U.S. stock market performance come to light.

To begin, the stock market is a forward looking mechanism, it’s a leading indicator. What that means is it trades on economic expectations up to six months into the future.

Next, the S&P 500 is market capitalization (market cap) weighted. Simply put, that means the higher the capitalization, the more of it there is in the index. Of the 505 stocks that make up the S&P 500 Index, only about a third have experienced positive returns year-to-date (YTD), with the remaining stocks have negative YTD returns. With that in mind, consider the chart below. It reveals the top five S&P 500 companies by market cap, their percentage of the S&P 500 total market cap, their valuation and price performance for 2020 so far:

As illustrated in the chart above, the combined market cap of the top five companies is 24.5% and the YTD gains of the big five are astonishing. Equally noteworthy are the elevated price-to-earnings (P/E) ratios. Given their disproportionate representation in the S&P 500 the YTD return is positive. However, equal-weighted S&P 500 Index provides a different story with a negative YTD return.

The question of “why the disconnect” has been brought up recently, reflecting investor views on the state of financial markets and their relationship with the economy, or lack thereof. This disconnect can be explained by the market capitalization weighted doing so much better than the equal weighted index. In addition, it’s a fair assessment that the stock market is optimistic in it’s outlook given the amount of stimulus from governments and central banks around the world.

WHAT DOES IT MEAN?

You may ask, is this unusual and what does it mean for the future? Do big stocks remain big stocks and how do they do after joining the list of big stocks? Our friends at Dimensional recently answered this question and the answer is a clear no, it is not unusual for the stock market to be concentrated in a handful of stocks. While there is an increase in concentration since 2017, the concentration was higher in the past:

2020-09-03 DFA largest stock percent chart (002).png

If we take a closer look at the history of the largest U.S. stocks by decade, we can see below that AT&T was among the largest two for six straight decades beginning in 1930, while IBM and Exxon were high on the list during the 70s, 80s and 90s. Both GM and GE were high on the list for multiple decades. Here are the largest 10 U.S. stocks at the start of each decade since 1930:

2020-09-03 DFA Largest stocks each decade.png

The concentration of the U.S. stock market in a few large companies, such as the FAANG stocks, is not uncommon. Rather it is more of an old normal than a new normal. The more important question to answer is what is the expectation of the high-flying mega cap tech stocks in the future? Let’s go back in history (1927-2019) and look at the price performance of the largest stocks following the year they joined the list of the 10 largest firms:

2020-09-03 DFA largest stock returns after joining list (002).png

The results are not nearly as superb as the climb to join the list of largest stocks. On average, the largest stocks continued to outperform by an annualized 0.7% over the following 3 years of joining the list and then underperformed the broad stock market by -1.1% over five years and -1.5% over 10 years. It appears once a stock has been on the list for a few years, it is more likely to underperform the broad stock market in the future. This is a reminder that it remains impossible to systematically predict the large companies that will outperform the stock market. No one knows what the list is going to look like in 2030. The lesson from history is that you are likely to underperform by chasing the largest market cap stocks. The larger the company, the more difficult it is to grow revenue and earnings. The higher the valuation, the lower the expected return in the future. When the Nasdaq peaked in March of 2000, it took 15 years to break out to a new record, which means if you invested in the Nasdaq index during March of 2000, it took 15 years to break even. It is best for your wealth building to avoid crowded/popular trades with high valuations.

Standardized Performance Data and Disclosures

Russell data © Russell Investment Group 1995-2019, all rights reserved. Dow Jones data provided by Dow Jones Indexes. MSCI data copyright MSCI 2019, all rights reserved. S&P data provided by Standard & Poor’s Index Services Group. The BofA Merrill Lynch Indices are used with permission; © 2019 Merrill Lynch, Pierce, Fenner & Smith Inc.; all rights reserved. Citigroup bond indices copyright 2019 by Citigroup. Barclays data provided by Barclays Bank PLC. Indices are not available for direct investment; their performance does not reflect the expenses associated with the management of an actual portfolio.

The ICE BofAML Option-Adjusted Spreads (OASs) are the calculated spreads between a computed OAS index of all bonds in a given rating category and a spot Treasury curve. An OAS index is constructed using each constituent bond’s OAS, weighted by market capitalization. The ICE BofAML High Yield Master II OAS uses an index of bonds that are below investment grade (those rated BB or below).This data represents the ICE BofAML US High Yield Master II Index value, which tracks the performance of US dollar denominated below investment grade rated corporate debt publically issued in the US domestic market. To qualify for inclusion in the index, securities must have a below investment grade rating (based on an average of Moody's, S&P, and Fitch) and an investment grade rated country of risk (based on an average of Moody's, S&P, and Fitch foreign currency long term sovereign debt ratings). Each security must have greater than 1 year of remaining maturity, a fixed coupon schedule, and a minimum amount outstanding of $100 million. Original issue zero coupon bonds, "global" securities (debt issued simultaneously in the eurobond and US domestic bond markets), 144a securities and pay-in-kind securities, including toggle notes, qualify for inclusion in the Index. Callable perpetual securities qualify provided they are at least one year from the first call date. Fixed-to-floating rate securities also qualify provided they are callable within the fixed rate period and are at least one year from the last call prior to the date the bond transitions from a fixed to a floating rate security. DRD-eligible and defaulted securities are excluded from the Index,

ICE BofAML Explains the Construction Methodology of this series as:Index constituents are capitalization-weighted based on their current amount outstanding. With the exception of U.S. mortgage pass-throughs and U.S. structured products (ABS, CMBS and CMOs), accrued interest is calculated assuming next-day settlement. Accrued interest for U.S. mortgage pass-through and U.S. structured products is calculated assuming same-day settlement. Cash flows from bond payments that are received during the month are retained in the index until the end of the month and then are removed as part of the rebalancing. Cash does not earn any reinvestment income while it is held in the Index. The Index is rebalanced on the last calendar day of the month, based on information available up to and including the third business day before the last business day of the month. Issues that meet the qualifying criteria are included in the Index for the following month. Issues that no longer meet the criteria during the course of the month remain in the Index until the next month-end rebalancing at which point they are removed from the Index.

ICE Benchmark Administration Limited (IBA), ICE BofAML US High Yield Master II Option-Adjusted Spread [BAMLH0A0HYM2], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/BAMLH0A0HYM2, January 10, 2019.

Past performance is no guarantee of future results. This information is provided for educational purposes only and should not be considered investment advice or a solicitation to buy or sell securities. Diversification does not guarantee investment returns and does not eliminate the risk of loss.

Investing risks include loss of principal and fluctuating value. Small cap securities are subject to greater volatility than those in other asset categories. International investing involves special risks such as currency fluctuation and political instability. Investing in emerging markets may accentuate these risks. Sector-specific investments can also increase these risks.

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Investments in foreign issuers are subject to certain considerations that are not associated with investment in US public companies. Investment in the International Equity, Emerging Markets Equity and the Global Fixed Income Portfolios and Indices will be denominated in foreign currencies. Changes in the relative value of these foreign currencies and the US dollar, therefore, will affect the value of investments in the Portfolios. However, the Global Fixed Income Portfolios and Indices may utilize forward currency contracts to attempt to protect against uncertainty in the level of future currency rates (if applicable), to hedge against fluctuations in currency exchange rates or to transfer balances from one currency to another. Foreign Securities prices may decline or fluctuate because of (a) economic or political actions of foreign governments, and/or (b) less regulated or liquid securities markets.

The Real Estate Indices are each concentrated in the real estate industry. The exclusive focus by Real Estate Securities Portfolios on the real estate industry will cause the Real Estate Securities Portfolios to be exposed to the general risks of direct real estate ownership. The value of securities in the real estate industry can be affected by changes in real estate values and rental income, property taxes, and tax and regulatory requirements. Also, the value of securities in the real estate industry may decline with changes in interest rate. Investing in REITS and REIT-like entities involves certain unique risks in addition to those risks associated with investing in the real estate industry in general. REITS and REIT-like entities are dependent upon management skill, may not be diversified, and are subject to heavy cash flow dependency and self-liquidations. REITS and REIT-like entities also are subject to the possibility of failing to qualify for tax free pass through of income. Also, many foreign REIT-like entities are deemed for tax purposes as passive foreign investment companies (PFICs), which could result in the receipt of taxable dividends to shareholders at an unfavorable tax rate. Also, because REITS and REIT-like entities typically are invested in a limited number of projects or in a particular market segment, these entities are more susceptible to adverse developments affecting a single project or market segment than more broadly diversified investments. The performance of Real Estate Securities Portfolios may be materially different from the broad equity market.

Fixed Income Portfolios:

The net asset value of a fund that invests in fixed income securities will fluctuate when interest rates rise. An investor can lose principal value investing in a fixed income fund during a rising interest rate environment. The Portfolio may also be affected by: call risk, which is the risk that during periods of falling interest rates, a bond issuer will call or repay a higher-yielding bond before its maturity date; credit risk, which is the risk that a bond issuer will fail to pay interest and principal in a timely manner.

Risk of Banking Concentration:

Focus on the banking industry would link the performance of the short-term fixed income indices to changes in performance of the banking industry generally. For example, a change in the market’s perception of the riskiness of banks compared to non-banks would cause the Portfolio’s values to fluctuate.

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