In an effort to gauge the level of frothiness in stock prices, we periodically like to analyze the stocks within the S&P 500 to determine the characteristics of the best- and worst-performing stocks. We begin with the premise that investor behavior is reflective of a constant struggle between two opposing emotions – fear and greed. During periods of time when greed is the dominant influence on investor behavior, stocks with more defensive characteristics will tend to underperform relative to those perceived to have more upside potential. Conversely, when investor fear is rampant, money flows into stocks that offer downside protection and a safe harbor during the storm. Based on these assumptions, we can slice and dice the components of the S&P 500 to see if any conclusions can be drawn. It goes without saying that this is not a highly scientific study, but we have found that these kinds of rough analyses can provide valuable insight into investor psychology.
We first looked at S&P 500 returns by market capitalization. Generally speaking, smaller capitalization stocks have historically produced better growth relative to larger companies, especially during times of robust economic growth. Therefore, when investors are optimistic about the economic backdrop, money tends to flow into smaller-cap names. Larger companies, on the other hand, tend to be more defensive in times of weak economic growth or recession due to their superior balance sheets, better access to the capital markets, and more diversified revenue streams. The chart below shows the results of our first analysis. The best returns so far this year have come from the second quintile (median market cap of $32 billion) and the fourth quintile ($12 billion), while the worst returns have come from the fifth quintile ($7 billion), which includes those companies with the smallest market caps. One might conclude that the inferior returns by the smallest companies reflects a degree of caution, and this could indeed be the case. However, we’d interpret the mixed results as fairly inconclusive given the inconsistencies within the other four quintiles.
We also looked at S&P 500 returns by debt rating (we used Standard & Poor’s). The rationale for looking at debt rating is similar to market capitalization – during times when investor fears about the economy are high, money will tend to flow into companies with stronger balance sheets while those with lower debt ratings will be shunned due to the potential for financial distress. The chart below shows that the returns for companies rated BB- and B+ were well below all the other categories. However, there are only two companies rated B+ and only eight companies rated BB- (out of 500). Given that returns across the rest of the ratings categories are fairly uniform, it is hard to draw any definitive conclusions here either.
Finally, we looked at the components of the S&P 500 by valuation. We used the ratio of stock price to trailing year’s earnings-per-share (EPS), and the results are shown in the chart below. It appears as though investors continue to favor companies with loftier valuations (quintiles 1-3) and continue to avoid companies with more reasonable valuations (quintiles 4 and 5). This preference for more expensive stocks, which admittedly has been going on for years, could be a sign that investor exuberance is becoming irrational. Why? Because investors are only willing to pay up for stocks if they believe one of two things is likely to happen – either earnings growth will justify the high price they are paying or someone else will give them a better price when they sell. However, if the growth doesn’t materialize or there are no “greater fools,” the stocks with loftier valuations (higher P/E multiples) have much farther to fall than their more affordable counterparts.
While company size and debt rating are not producing any conclusive evidence, the ongoing outperformance of more expensive stocks seems to reflect the continued triumph of greed over fear. Greed is prevailing because investors have become conditioned (largely by Fed policy) to expect that a strategy of fully embracing risk will continue to pay off. For our part, we think investors are underappreciating the magnitude of the risks, and so we remain defensively positioned. In the game of musical chairs, it’s important to have a chair when the music stops.