Market Leadership is Narrow and Could Change
“Just when I thought I was out, they pull me back in.” - Godfather III
As investors, it’s easy to relate to Michael Corleone’s frustration. Often, when the economy is humming along, stocks can provide highly favorable returns and then wham, markets abruptly change course. Recent examples of pain include: 1) the bursting of the dotcom bubble, 2) the sharp economic and market declines during the Great Financial Crisis, 3) early days of the Covid-19 pandemic and 4) in 2022, when the Fed raised short-term interest rates sharply to combat high and persistent inflation. Surprises – both welcome and otherwise are to be expected although often decidedly hard to predict. Also, history shows that leadership can and frequently does change dramatically.i While predicting adverse events with precision is inherently difficult, we believe prepared and patient investors can have reason for long-term optimism.
The volatility of the stock market is something to behold.ii The good news is the U.S. economy (as measured by GDP) tends to fluctuate modestly compared to earnings per share of the S&P 500 which also tends to be far less volatile compared to the price change in the S&P 500 (and other major market segments). Stock prices are highly volatile due to the tendency for significant increases and decreases in things like the price to earnings (PE) ratio and other valuation metrics along the way. While foreknowledge of exogenous events is hard to come by, investors are well-served to adopt a rational, disciplined approach to investing. This includes adopting a long-term posture to owning investment assets while also using valuation metrics as a key input into purchase and sale decisions. These measures can help investors avoid the temptation to get in and out of stocks at what prove to be inopportune times. As you will see, I have also included a table of GDP growth in an endnote.iii
When the upturn in an out-of-favor segment happens, including U.S. growth stocks in 2009, most investors have little or no ownership. The prevailing thinking about those who are out is ‘Let someone else suffer.’ Conversely at what have proven to be epic tops, many investors are over exposed/concentrated. Sadly, most investors have poor timing skills. Emotion trumps reason at extremes – because fear and greed overcome rational thinking. It only looks easy during the best of times – ‘just follow the yellow brick road.’ In aggregate, we make the repeated mistake of imagining we are only a totally new world of growth and certainty where valuation considerations are largely irrelevant. When returns are lackluster let alone during extended periods when losses are prevalent and the financial news is grim, staying in stocks feels downright fool hearty. That’s why we are steadfast proponents of diversification.
For the remainder of this letter, I thought it might be helpful to share some charts and graphs that caught our attention and provide brief commentary to aid your review.
The period of dominance by large cap growth stocks is not new, but it is unusual. The next chart shows that usually the aggregate change in value for the bottom 490 stocks in the S&P 500 exceeds the growth in the top 10 by market cap.
As the chart above shows, the equal weighted bottom 490 stocks exceeded the return for the top 10 components by an average of 2.4% per year since the inception of the S&P 500 on March 1, 1957. That said, mega caps outpaced the returns for the rest of the S&P 500 index in the mid-1960s thru year end 1972 and in the late 1990s and since 2013. Clearly no market segment is always best, but on average, ownership of the top 10 names has under-performed most of the time. While difficult to time, the outperformance is mega caps appears to be long in the tooth.iv
U.S. indexes have outperformed most international segments since the Great Financial Crisis (GFC). The S&P 500’s return has been aided by increases in the PE (price to earnings) and other valuation metrics relative to international markets. For the most part, valuations for international markets are relatively attractive compared to their own long-term metrics and relative to the S&P 500.
Historically, emerging markets have performed relatively well when the Federal Reserve has lowered the Federal Funds rate. The FED may begin reducing this key rate again soon.
In summary, large fluctuations in stock prices are to be expected, but they are often inherently hard to predict. Surviving the worst market environments is essential. While favorable and unfavorable trends in leadership can persist, it can be helpful to extend one’s time horizon and ask things like what could cause leading segments to lag or lagging segments to lead on a multi-year basis? When the news is highly favorable, valuations have been known to reach levels that prove unsustainably high and vice versa. Diversification can seem like costly and unnecessary insurance when market segments like the S&P 500 reign supreme. Of course, we recognize that top performing segments can continue to deliver heady returns.v However, we are equally cognizant of the roughly 50% declines from the top of the market in late 1972, early 2000 and late 2007. It took many years for the S&P 500 to make new highs. We also know that during these painful periods for the S&P 500, that other segments performed at least relatively well. That’s why we intentionally hold meaningful allocations in equity market segments that have historically performed differently over time. We also like to hold investments in shorter-term fixed income due to this asset’s tendency to largely hold value relative to equities when stocks are in periods of decline. By pairing securities that don’t tend to move in sync, investors can reduce the risk of adverse timing and the strong urge to make wholesale changes along the way.
As always, we welcome your questions and comments. We are otherwise keenly interested in helping you.
Richard Jones, CFA
Partner, Harmony Wealth Partners
i
ii
Source: Macrotrends.net
iii
In shorter time periods (top panel) valuation does not predict subsequent price change. Over periods of 5 or more years, current valuation does tend to help identify times of risk and reward. When valuation is low, subsequent 5-year returns tend to be high and vice versa. Mega caps are outperforming today like they did in the late 1990s. That could change.
v
Data thru close on Friday 7/19. Clearly a week of market change does not constitute a new trend. Mega caps could rebound significantly and/or small caps can falter. That said, a combination of lower inflation could lead to lower interest rates without triggering an economic slowdown. That could be a good environment for U.S. small caps and international markets too.
The S&P 500 is an unmanaged index of 500 widely held stocks that is generally considered representative of the U.S. stock market. Opinions expressed in the attached article are those of the author and are not necessarily those of Raymond James. All opinions are as of this date and are subject to change without notice.
