At the risk of sounding repetitive, I feel compelled to revisit a trend that has been remarkably consistent and powerful over the past several years. A small number of very large stocks continue drive the gains for the broader stock indices. One way to show this is to look at the performance of the S&P 500 compared to the performance of an index of S&P 500 companies using equal weightings. But first, it helps to understand how the S&P 500 index is calculated. The S&P 500 is a market capitalization-weighted index, which means that the relative market valuation for each company is the factor that determines how much influence it has in the overall index. For example, Apple has a current market value of about $1.56 trillion. That $1.56 trillion amounts to a little more than 5% of the total market valuation of the S&P 500. Therefore, the performance of Apple’s stock going forward will account for about 5% of the performance for the overall S&P 500. Easy enough?
Invesco offers an exchange-traded fund (ETF) that allows investors to get exposure to the S&P 500 companies another way. For the Invesco S&P 500 Equal Weight ETF (ticker symbol RSP), the performance of each S&P 500 company is given the same amount of influence on the overall ETF’s performance. Apple and other mega-cap stocks no longer carry outsized influence but rather are assigned a weighting of 0.20% just like every other company in the index (100% divided by 500 companies).
In the first chart below, you can see that the Invesco Equal Weight ETF has well under-performed the S&P 500 over the past five years. The reason for the disparity is the outsized influence of the FAANG stocks (Facebook, Apple, Amazon, Alphabet, Netflix and we include Microsoft), which now account for almost 22% of the S&P 500’s total market capitalization. Because the FAANG stocks as a group, including Microsoft, have dramatically outperformed the remaining 494 companies in the S&P 500, the S&P 500 has far outperformed an index using equal weightings for all 500 stocks.
A better way to show the same trend is an analysis done by Jeffrey Gundlach, the legendary investor at Doubleline Funds. Mr. Gundlach ran the performance of the aforementioned FAANG stocks (which he calls the “Super 6”) as a group, and compared their performance to the performance of the remaining 494 companies in the S&P 500. For good measure, Gundlach also showed the performance of a broad index of non-US stocks in both developed and emerging markets. The analysis covers the past 5+ years through May 18, but the trends remain firmly in place today. The Super 6 stocks have absolutely crushed both the S&P 500, ex the Super 6, as well as the index of non-US stocks. In fact, we estimate that annualized returns for the S&P 500 would have been in the low single-digits if we remove the contribution from the Super 6.
We continue to urge investors to tread lightly with regard to the handful of names that have been so heavily favored by investors for a long period of time. The mega-cap stocks may not get broken up by the government for anti-trust violations. The combined value of the FAANG stocks, to include Microsoft, is now well over $5 trillion dollars. By comparison, the third largest economy in the world, Japan, is a little under $5 trillion. While that may be a meaningless statistic, I’ve always found it helpful to do periodic reality checks like this. In 2006, it didn’t make a heck of a lot of sense to us that people were buying condos as investments and flipping them a few months later for profits in the hundreds of thousands. It didn’t make sense that banks were writing pay-option adjustable-rate mortgages without income verification/documentation. And it didn’t make sense that the rating agencies were rubber stamping sub-prime mortgage-backed securities without proper due diligence. Are we in the same situation now with the FAANGs? Obviously not, but the level of blind faith that investors have shown to these few stocks is reminiscent of the “nifty fifty” stocks in the 1960s and 1970s. Please be sure what you’re doing before blindly piling on!
It goes without saying that all FAANGs are not created equal. Each must be evaluated individually on its own merits. We own some of them in our client portfolios because they have promising long-term growth prospects, fortress balance sheets, and trade at reasonable valuations. But our position sizes are responsible within well diversified portfolios, and we stand ready to trim or sell the positions if and when our investment criteria no longer apply. If you believe in mean reversion at all, it stands to reason that now would be a good time to have decent exposure to the other 494 companies within the S&P 500!