When the Facts Change
Renown economist John Maynard Keynes is commonly accredited with saying, “when the facts change, I change my mind.” In the spirit of this mindset, we would like to take a second to discuss some key facts we are observing in the stock market today that are devoid of emotions like fear or hope that dominate today’s headlines.
The first analysis we will do is looking under the hood of some of the major indices that have outperformed so far this year. Of the three major indices, the Nasdaq 100 Index has far and away been the outperformer so far this year. The Nasdaq 100 is an index of 100 of the largest, most actively traded U.S companies listed on the Nasdaq Stock Exchange. When looking under the hood, however, the makeup of its performance so far this year is concerning. The top five companies in the Nasdaq 100 are megacap companies that should be familiar: Apple, Microsoft, Amazon, Google, and Facebook. As of last Monday’s (July 13th) close, these five companies make up over 77% of the Nasdaq 100’s return year-to-date (YCharts). For comparison, these five companies only make up around 46% of the index’s holdings. When an index’s performance is so heavily concentrated in a select group of stocks, it typically is not indicative of a healthy market environment. In the same way you would diversify your own investments, having such narrow leadership in an index can spell trouble when and if those leaders begin to lose steam.
In the same way the Nasdaq 100 has narrow leadership, both the cap-weighted S&P 500 technology and consumer discretionary indices have seen megacaps skew their performance. As a refresher, a cap-weighted index is an index that bases the size of each holding off their market capitalization (stock price times the number of shares outstanding). Currently, Microsoft and Apple make up just under 44% of the cap-weighted technology index, yet they make up over 86% of the index’s performance year-to-date (YCharts). Likewise, Amazon makes up nearly 26% of the cap-weighted consumer discretionary index. Amazon’s weighted performance means that it currently makes up 17.6% of the index’s 4.9% return year-to-date, meaning that the other holdings are accounting for a return of -12.7%. With heavy concentration like this, it’s not surprising that the dispersion between the cap-weighted sectors and the equal-weight sectors is abnormally high. Over the previous five years, the average outperformance by the cap-weighted technology sector versus the equal-weight technology sector was around 1.8%; this year, it has outperformed the equal-weight technology index by over 15%. Similarly, the average outperformance by the cap-weighted consumer discretionary index over the past five years has been 6.5%; this year, it has outperformed its equal-weight counterpart by nearly 33%! Just like the Nasdaq 100, even certain sectors with exposure to these megacap leaders are top-heavy to say the least.
Another way to observe narrowing leadership is to review the top five holdings of the S&P 500 relative to history. Currently the top five holdings in the S&P 500 make up over 25% of the index. For comparison’s sake, the top five made up just over 17% of the index at the end of 2019. When you see the concentration of the top five holdings spike like this, it is usually due to three possibilities: the top five are way outperforming the rest of the index and increasing their size, the rest of the index is doing poorly relative to the larger names, or both possibilities occurring at the same time. In today’s environment, it appears that both are happening; while the megacaps continue to outperform, the rest of the index continues to lag considerably behind them. It is worth noting that not only is this the largest concentration for the top five stocks since 1964, but it is also the largest year-over-year increase since the jump from 1998 to 1999 during the Dot-Com Bubble (S&P). While there is no guarantee that we are on a collision course with a similar crash of that magnitude, it is worth keeping an eye on this group.
The last fact we would like to mention is the current valuation of the market. The Buffet Indicator, a valuation indicator coined by Warren Buffet, observes the Wilshire Total Stock Market Index (a cap-weighted index of over 3,400 U.S. companies) versus U.S. GDP. Today this valuation indicator sits not only just below its historical high but is even higher than its peak during the Dot-Com Bubble. In short, the Buffet Indicator currently says that the market today is severely and historically overvalued relative to the fundamentals of our economy.
While it can be confusing to see market indices rise when it seems the rest of the economy is doing poorly, we thought it would be best to provide some insight into what is actually driving these indices. Narrow leadership in the megacaps can seemingly keep things afloat, but the risk of these losing steam and joining the rest of the laggards in the index causes us to continue to remain cautious; the market is going to need greater participation in all areas before this can be considered a healthy market environment. We will continue to monitor the economy and the markets on both the fundamental and technical sides, and we will be sure to notify you of any material changes we observe. In the meantime, don’t hesitate to reach out if you have any questions or concerns. Join Ashley every Wednesday as she provides her Mid Week Market Update video on both our Youtube and Facbook pages.
Ashley Rosser AIF, BSN
The opinions voiced in this material are for general information only and are 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 not be invested into directly. The Standard & Poor’s 500 Index is a capitalization-weighted index of 500 stocks designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries.