In our November 25, 2015 Market Commentary, Market Leadership, we discussed how the top 20 best-performing stocks in the S&P 500 had contributed nearly 4 percentage points to the year-to-date return (not including dividends) for the overall index. Those top 20 stocks, which on average were nearly twice as big (by market cap) as the average S&P 500 company, had produced an average return of +59% compared to -3% for the remaining 480 companies within the index. Without the contribution from those 20 stocks, the S&P 500 would have been down 3% on a year-to-date basis compared to the +1% actual return.
So, through 10+ months of 2015, S&P 500 index performance had been driven by just a select few, and relatively large index components – a trading environment described as having “weak market breadth.” We went on to say that “market tacticians generally interpret low market breadth as a potential warning sign. In other words, as market leadership gets smaller and smaller, it could be a harbinger of broader market weakness.”
Unfortunately, the tea leaves were proven right. The S&P 500 has now nearly retraced its late-summer swoon and currently sits in “correction” territory (down 10% or more from highs). The strange thing, though, is that the market’s breadth has not really improved. I received a call from Adam Shell at USA Today last week. Adam wanted my thoughts on the internal performance weakness that is not being captured in the major market averages for his article, Stealth bear market mauls Wall Street. For instance, the S&P 500 is now down about 11% from its all-time high in May 2015. However, if we look at the individual stocks within the index, the average S&P 500 stock is down about 24% from its respective 52-week high. A pretty stunning statistic, right?
The major index averages appear to be hiding a lot of pain for investors. In other words, investors who haven’t owned the handful of stocks that have done extremely well, including Facebook, Amazon.com, Netflix, Google (now called Alphabet), among others, are highly likely to have well underperformed the index over the past year. Since the S&P 500 is weighted by market capitalization, the largest companies are much more important to overall index performance. Take the aforementioned “FANG” stocks, for instance. These four stocks have been very supportive of the overall index since the market high on May 21, 2015. In addition to rising an average of 27% compared to the S&P 500’s loss of about 11%, these stocks are nearly 8 times as large, on average, as the average S&P 500 stock. In fact, taken as a group, these four stocks now account for about 6% of the total S&P 500 market cap (based on current market caps). It’s easy to see how the index’s fate can be determined by a relatively few stocks.
There is a positive note to be drawn from this data. Importantly, the fact that the average S&P 500 stock is down 24% from its respective 52-week high should be viewed as an opportunity by astute investors. This is because valuation adjustments for a large percentage of stocks have already been quite meaningful, and therefore expected future returns should now be a lot more attractive. This is another way to say that the risk/return profile has improved. Long-term investors should look through the noise and volatility and establish positions in companies with strong fundamentals and the ability to withstand some turbulence in the capital markets.