It was recently reported that the S&P 500 Index has again reached all-time highs as we go through the sixth month of the economic recession of this year. How is it possible that when the economic data seems so bad that the stock market is reaching new levels? Are all businesses really doing that well?
The S&P 500 Index, often referred to as “the market” in the media, is a market-cap weighted index. A company’s market capitalization is determined by its shares outstanding multiplied by its price. The higher the market capitalization of a company, the larger a company’s concentration will be in the index. The S&P 500 Index is comprised of the largest 500 U.S. publicly traded companies. Since there are thousands of public companies in the U.S., the S&P makes up a small piece of all the companies you could invest in but includes some of the largest and well-known companies.
Since the index is just a method of tracking and benchmarking performance, if an investor wants to invest in an index they can use an ETF or a mutual fund that tracks a particular index (there are many indices). There are many investment vehicles available to track the S&P 500 Index. However, what is useful when considering the effect that concentration has on performance, is to compare the performance to an equal weighted S&P 500 Index. The equal weighted index takes the same holdings used in the Market Cap S&P 500 but equally weights them. So, for example, in the market cap weighted S&P 500 Index Fund (SPDR S&P 500 Trust), Apple makes up 7.21% of the index (as of 8/24/2020) while in the equal weighted S&P 500 Index Fund (Invesco S&P 500 Equal Weight ETF), Apple makes up just 0.27% of the fund.
Recently the market cap weighted S&P 500 Index has become more concentrated in the top five holdings (Microsoft, Apple, Amazon, Facebook and Alphabet (Google)), than it was even in the late 1990s during the dot com bubble, as illustrated in this chart from Goldman Sachs via Business Insider:
Since this chart was issued in April, the S&P 500 Index has continued to grow more concentrated as the top five holdings now make up 21.8%. The chart below shows the year-to-date performance of the top five stocks as well as the performance of the market cap weighted S&P 500 Index Fund (SPDR S&P 500 Trust) and the equal weighted S&P 500 Index Fund (Invesco S&P 500 Equal Weight ETF). As shown below, the equal weighted S&P 500 fund is down -4.35% while the market cap weighted S&P 500 fund is up 6.52%. The double digit returns of the top five holdings have had a big impact on the performance of the market cap weighted fund, leading to the outperformance compared to the equal weighted S&P 500 fund this year.
Historically, the Equal Weighted S&P 500 Index tends to outperform the Market Cap Weighted S&P 500. Below is a chart comparing the index’s performance from 1990 through August 24, 2020. The lines in grey are U.S. recessions.
As you can see in the chart above, there have been times in the last 30 years where the market cap weighted S&P 500 performs better than the equally weighted S&P 500 or the gap in performance has narrowed. Below is a chart showing the ratio between the two funds to visually show the narrowing and spread of the indexes over time. When the line declines from left to right, the market cap weighted S&P 500 is outperforming and when the line increases from left to right, the equal weighted S&P 500 is outperforming.
So what does all of this mean? Historically, after periods where the market cap weighted S&P 500 becomes highly concentrated and the performance gap narrows, it is generally followed by periods of underperformance in this index where the performance gap grows. In the above chart this is evident in the early 2000s and the Great Recession from 2007-2009.
As the charts above indicate, when people continue to pour money into names that they feel are strong, it pushes up the valuation of these top few companies and drives up their concentration in the S&P 500. Then, as these stocks begin to become too expensive from a valuation perspective, and other companies begin to look attractive as economic conditions improve, money begins to rotate into other areas of the market. This leads to the equal weighted S&P 500 beginning to once again outperform the market cap S&P 500. While no one knows when things will shift, it is beginning to look like the market is out of balance and there will come at time once more when the broader market performance will outshine the more concentrated market cap weighted index.
While this is what history tells us, there is always a chance that things could be different this time. Occasionally, shifts in culture and society lead to outperformance of certain sectors that diverge from historical norms. Only time will tell if this is history repeating itself or a new era. This is why we structure our portfolios to be broadly diversified and don’t make bets just because a trend looks to be emerging.
When we invest our client’s money, we look to be broadly diversified in our allocation. We allocate funds to many investments, including the “big 5” currently representing the top holdings in the market cap index, but we are cognizant to not excessively overweight any investment holding. When we rebalance portfolios, we rebalance back to our targeted allocation; we sell areas that have been performing better, and therefore are “more expensive”, and buy into areas that have not grown as much and are “on sale”. We work with each client family to determine the right level of risk for their plans to ensure that, even in uncertain market conditions, they feel comfortable with how they are invested.
For more information on the concentration of the S&P 500 and how we structure our portfolios to be broadly diversified, please reach out to your Cassady Schiller Wealth Management Advisor.
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. There is no guarantee an investing strategy will be successful. Diversification does not eliminate the risk of market loss. All expressions of opinion are subject to change. This article is distributed for informational purposes, and it is not to be construed as an offer, solicitation, recommendation, or endorsement of any particular security, products, or services. Investors should talk to their financial advisor prior to making any investment decision.