If you’re like a lot of people, you’ve been thinking, “why is the stock market doing so well when the news is so grim and the economy is still struggling?” To understand what’s going on, let’s compare the stock market to college football. Think of the S&P 500 Index as being made up of the Big Five and then you have all the rest of the 495 “teams.”
Although the S&P 500 is comprised of the 500 largest stocks in the world, the Big Five – Microsoft, Amazon, Apple, Google, and Facebook – have had a vastly outsized impact in recent years. Both in terms of size and performance, these stocks have been dominant.
Dominance of a Few
Think of this list: Alabama, Clemson, LSU, Ohio State, and Oklahoma. Now you can argue about whether there are a couple different schools that should be included here instead, but the larger point remains. The Bowl Championship Series has been dominated by just a handful of organizations. In fact, for five years in a row, either Clemson or Alabama (or both) have played in the National Championship.
Historically, this trend of a short list of dominant teams has held up, although the list of top names has changed over time. In the 90s, Florida, Florida State, Miami, and Nebraska were seemingly always in the top tier.
An Outsized Influence
Like college football, the most dominant names in the market change over time. Twenty years ago, Microsoft was already one of the largest companies in the world, but the other four biggest names were very different then. GE, Cisco, Exxon, and Walmart were the on that list at a time when smartphones didn’t yet exist and the closest thing to social media was Yahoo Messenger.
The point is that top organizations change, but the trends tend to be pretty stable for years at a time. And those big names at the top of the list have a vastly outsized impact on the stock market as a whole, for better or worse.
To illustrate this point, take a look at this chart from MarketWatch. It’s a visual representation of the market capitalization of the five largest companies as compared to the 282 smallest companies in the S&P 500.
NOTE: This chart is from 2018 and the Big Five have grown even larger relative to the smaller firms since then so the difference has become even more dramatic.
A Common Misunderstanding
Novice investors are often surprised by this. They think of the S&P 500 Index as being made up of 500 stocks that are equally weighted (meaning each would be worth 0.2% of the total value). But the S&P is a market-cap weighted index rather than equal-weighted one. That might sound like an obscure distinction, but it makes an immense practical difference.
If all of the companies in the S&P 500 were weighted equally, the Big Five would account for a total of 1% of the overall value (5 divided by 500 = 1%). Instead, these five stocks actually make up more than 22% of the total value of the S&P 500 Index.
Bigger is Better (At Least Thus Far)
In a year like we’ve had this far in 2020, the mega-cap tech stocks have thrived while much of the rest of the stock market has struggled. You may have seen the recent headlines that the market is near an all-time high. That is true only because of the overweighting of the Big Five stocks and others like them in the S&P 500 Index.
Here’s a chart that shows the performance of the Big Five versus the 495 other stocks in the S&P 500 Index from the beginning of this year through mid-July:
The one caveat to add here: Like all analogies, this idea of a Big Five has its limitations. The fact is there is not so much of a bright line between the top 5 stocks and all the others. If you look at the 50 largest stocks in the S&P, many of those more closely represent the attributes of the Big Five than they do the rest of the stocks in the broader market. In other words, you can make a strong case for adding a number of other stocks from the ‘495’ category to the Big Five.
So Now What?
As our compliance department routinely reminds us, past performance is no guarantee of future results. The markets and economy move in cycles and, therefore, what goes up must come down. The cyclical nature of the markets is the reason our firm created and implemented an individualized Recession Prep Scorecard for each of our clients last year.
We didn’t have any idea what was in store for us in 2020. We knew we couldn’t predict the future, but we could prepare for it. From an investment management standpoint, we prepared in two main ways:
- Create “dry powder” by selling a portion of stock investments (while the stock market was still in the midst of one of the longest bull markets in history) and have it ready to invest opportunistically during a future downturn.
- Invest in companies that have “staying power.” We have intentionally overweighted large, blue chip, growth-oriented stocks since these would (hopefully) hold up better than the broader market during a downturn.
At this time, we still advocate for this approach (#2 above). While this trend will end at some point in the future and a new type of investment will take over the reins, for now we believe the largest, most well-capitalized companies are still the best bet.
We favor stocks of companies with strong balance sheets, sustainable earnings, and universally recognizable brands with deep customer loyalty. In times of uncertainty, these are the types of investments that should be able to sustain through the crisis, regardless of how long it takes. We look for the types of investments that can do well…even until that long-awaited time that we can again attend a live sporting event.
Disclosure: Content in this material is for general information only and not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly.