Understanding the S&P 500 Index
On August 18th, the S&P 500 Index hit a new all-time high after having recouped its losses for the year. Since then, it has continued to move mostly higher. Many investors interpret this as meaning that all stocks are back to their highs of the year, but that is not the case. Here’s why:
The S&P 500 Index represents the largest 500 stocks in the US and is constructed as a market capitalization-weighted index, meaning that larger companies represent larger slices of the index. Over the last several years, many technology and consumer discretionary stocks like Facebook, Apple, Netflix, Microsoft, Amazon, and Google have had a tremendous gain in stock prices. So much so that these high-flying stocks have earned their own acronym: FANMAG.
Because several of the largest names in the index have had some of the best performance over the past few years, those stocks have grown in market cap size faster than others and now represent an even larger percentage of the overall index. For context, the top five companies in the S&P represent 23% of the index, while the bottom 400 companies represent less than 30%.
Let’s take a look at how those different groups have performed so far this year compared to the index. The S&P 500 Index is +6.7% year-to-date (including dividends). The FANMAG stocks are up an average of +45.0%, while the bottom 400 stocks in the S&P 500 are down an average of -6.6% – a huge difference.
If we slice the index a different way, we find that the stocks that are up year to date (~230 companies) are up an average of +19.0%, while the stocks that are down year to date (~270 companies) are down –22.1%. If the index was equally weighted among all its constituents, it would be down -3.1%.
This underscores two important dichotomies currently underway in the market and the economy:
1) The performance of the S&P 500 Index is not a pure representation of stocks in the market.
We clearly see from the data above that although the S&P 500 Index is higher by +6.7% on the year, there are still many companies for which the challenges are far from over. Below is a table of the best performing and the worst performing stocks year to date:
As you scan the list, a few items of note stand out. Many of the best performing stocks are in the technology and healthcare sectors – arguably the two sectors that have benefitted the most from the global pandemic, as people rely more on technology for communication and delivery of goods. Likewise, many of the worst performing stocks are from areas of the economy that have been worst hit by COVID – the energy sector and travel industry, as people travel less and in turn use less energy (e.g. oil and gas).
2) The “stock market” is not the economy.
While things appear to have recovered on Wall Street (if viewed through the lens of the S&P 500 Index), there is still some pain on Main Street. Small businesses continue to have challenges operating under COVID restrictions. Reduced capacity restrictions result in fewer sales and additional sanitation procedures lead to higher costs, both of which lead to lower (and sometimes negative) profitability. Stories of small business shutdowns are all over the news, leading some investors to worry that the stock market has “decoupled” from reality. However, the reality is that the largest companies in the US (represented by the S&P 500) are better capitalized, and consequently, better able to weather the storm than the smaller restaurants and boutiques operated as sole proprietorships that show up on the news.
The good news is that with each passing day we draw closer to a vaccine (or a widely available treatment protocol). The longer that businesses large and small can hang on, the better the recovery will be for them once a cure is found. That’s because the businesses that declare bankruptcy usually tend to be weaker competitors (those that are either less well-capitalized or have weaker profit margins because they compete on lower prices). Elimination of those types of competitors – especially the ones that underprice their goods – is similar to a forest fire. It’s an unpleasant occurrence to witness, but one that generally results in a stronger system in the future.
As we near the end of the pandemic, we could see the economy begin to pick up steam as life starts to return to normal, which would cause corporate profitability across the board to rise. At that point, we may start to see a “leadership rotation” where growth stocks (e.g. technology and healthcare) which led the rebound higher begin to stall. Value stocks (e.g. those smaller names in the market which operate in industries currently out of favor) could then begin to outperform as investors pivot to companies that offer higher future profit growth due to their higher current fixed costs (a concept known as operating leverage). At that point, the recovery would be much broader and more inclusive, signaling a healthier economic recovery.
Either way – leadership rotation, or status quo – no matter how the final four months of the year shake out, we are here to encourage investor discipline and stand ready to take advantage of any volatility that may occur to add value to our clients’ long-term financial situations.
Note: S&P 500 Index data is as of 9/9/2020.