Leadership Continues to Narrow

In our May 9th Market Commentary, we wrote that through strong appreciation this year, the five largest companies in the Nasdaq 100 Index had grown to comprise well over 40% of the total index.  Well, it’s now nearly a month later, and the massive amount of money flowing into those same five stocks continues.  For the year-to-date period through last Friday, the five stocks – Apple, Alphabet (formerly Google), Microsoft, Amazon and Facebook – produced an average total return (including dividends) of over 29%.  Their combined market capitalization is now almost $3 trillion, which exceeds the Gross Domestic Product (GDP) of all but four countries!  Given the continued strength in these behemoths, we thought we’d take a look at how their performance this year has influenced the total return of another index – the S&P 500.

*Source: Standard & Poor’s and Bloomberg

Through last Friday, the S&P 500 had produced a total return of 9.9% for the year.  As mentioned above, the five behemoths produced an average return of over 29% over that same time frame.  Obviously, these companies, which represent just 1% of the companies in the index but about 13% of the market capitalization, have had a positive effect on S&P 500 returns this year.  How positive?  Based on my calculations, the five have contributed a whopping 3.5 percentage points to the year-to-date total return (including dividends) for the S&P 500.  So those five names were responsible for 35% of the S&P 500’s total year-to-date return.  This is a massive contribution by such a small number of companies.  The remaining 495 companies contributed just 6.4% to the total index return.  To state it another way, the S&P 500 would have produced a total return of just 6.4% if the five highlighted companies had returned 0% for the period.

Can we expect a similar contribution from the same five companies in the second half of the year?  What would happen to overall S&P 500 returns if the five companies were to give back their average year-to-date return of 29% in the second half of the year?  Would the remaining 495 stocks in the index be unaffected by such a sell-off?

Most investors believe that owning an index fund (like the SPY, which seeks to replicate the returns of the S&P 500) provides diversification.  It does, but not as much as you might think with 13% of the S&P 500 made up of just five names.  Moreover, these five stocks are more volatile than the average S&P 500 stock as each stock’s beta is above one.  Beta is a metric that measures a stock’s volatility in relation to the overall market.  Volatility is one measure of risk, and investors generally require higher returns in exchange for the assumption of higher risk.  So it makes sense that the these five stocks have outperformed the overall market.  However, the magnitude of the outperformance is highly unusual.

Professional investors generally prefer to see a market rally that is more broad-based, or driven by a large number of companies and industry groups.  When leadership narrows, it often indicates that the broader market may be running out of steam.  Furthermore, investors love the kind of volatility that results in higher stock prices.  We call this upside volatility.  However, it is generally the case that what goes up can also come falling down (and many times in much quicker fashion).  Our point is that if the only type of volatility that existed was upside volatility, all investors would own the same high-volatility, or high-beta stocks.  This seems to describe, to a certain extent, the current environment.  But just as the reward for assuming higher risk is higher returns (over time), the price of reaping those higher returns is occasional downside volatility.  Investors have not been subjected to any significant downside volatility in these names in quite some time.

These market conditions could last a good while longer or not.  With the major market indices trading near all-time highs, and leadership heavily concentrated, caution is required.  The risk becomes complacency and disappointment when caution goes unrewarded for too long or is abandoned just before it is needed.