In a year replete with unprecedented and unfathomable developments, one of the most remarkable is the resilience of the equity market in the face of a global pandemic and the sharpest economic contraction in history. As the extent of the COVID-19 crisis and the economic cost of the effort to constrain its spread became evident, stocks panicked into the unknown from late February into March, dropping 34% in 23 trading days. And then the market turned on a dime. Starting on March 24, the S&P 500 rallied close to 18% in just three days, and then kept on going straight up. Even as death tolls and historically awful economic news continued to mount, stocks moved higher and higher, closing last Friday 32% up from the lows of late March. The S&P 500 is now higher than it was at this point in 2019 and down just 7.8% since the beginning of the year. How can this be? How can the stock market seemingly ignore the very real health and economic challenges that this nation still faces and be so disconnected with reality?
History provides the outline of an answer. Financial markets are discounting mechanisms: The value of any asset – be it stocks, bonds, real estate or art – is simply the net present value of all the future cash flows that the asset is expected to provide, whether dividends, coupon payments, rental income or the ultimate sale of the asset at the end of the holding period. The value of an asset depends, therefore, not so much on today’s market environment, but on what investors expect the future environment to be, and the interest rate at which those future expectations are discounted. Although headlines remain troubling at present, investors are looking forward to a future in which continued progress on the healthcare front allows economies to return to some semblance of normality. By the time these positive developments dominate the news cycle, the market will be far down the road to recovery.
Thus it has always been. Although the catalyst of the 2008-09 global financial crisis was rooted in finance instead of biology, the psychology of forward expectations played out as it always has. The S&P 500 bottomed at 676.53 on March 9, 2009, and rose sharply even as the economic crisis continued. The recession did not end until the summer of 2009, by which point equities were 37% higher. The labor market continued to deteriorate, and unemployment didn’t peak until November 2009, when the stock market was up 63% from the trough. By early 2010, it started to become evident that the job market had decidedly begun to recover and that the worst of the financial crisis had passed. Once this good news made it into headlines, a new bull market was a year old and 71% underway.
No one rings a bell at a market bottom. It is possible that history is repeating itself again, while it is also possible that the market is celebrating progress in reducing the health and economic impact of COVID-19 without acknowledging the difficulty of restarting economic activity. Additionally, the prospect of further outbreaks poses the risk of needing to dial back economic activity again in the future.
What is different this time around is how narrow market leadership is. Most indices – including the S&P 500 – are constructed based on market capitalization. Larger companies therefore have greater influence on the level and movement of the index. This can lead to a skewed sense of reality when a small subset of large companies performs differently from most of the companies in the index. This is the current state of affairs, and when we take this into account, market performance in 2020 isn’t all it’s cracked up to be.
This is best illustrated by comparing the familiar capitalization-weighted S&P 500 index to an equal-weighted index of the same companies. In the nearby graph, we compare these two measures of equity performance, both indexed to start at 100 on January 1, 2015. Over the whole time period through May 22, 2020, the capitalization-weighted S&P 500 is up 44%, whereas the equal-weighted index is only up 20%. As the graph implies, this performance gap of 24% is a relatively recent development: The gap was less than 1% at the beginning of 2017, widened to a mere 4% at the beginning of 2018 and grew modestly to 8% at the start of 2019. Over the course of last year, however, the performance differential accelerated to 13%, and has now doubled from there.
We needn’t look far to identify the small handful of companies responsible for this widening performance differential. The five largest companies in the S&P 500 by market capitalization are Microsoft, Apple, Amazon, Alphabet and Facebook, and together they account for over 20% of the total value of the index. These are among the most widely owned stocks in the market, particularly by index funds, and have vastly outperformed the overall index. Amazon has led the way with a rise of almost 32% since the beginning of the year.
This range of returns is astonishing, particularly in the context of a relatively short time period. From the beginning of the year through May 22, smaller-capitalization stocks (as measured by the Russell 2000) are down 18.3%. As discussed above, the equal-weighted S&P 500 is lagging the capitalization-weighted index by -16.0% to -7.8%. By contrast, the index’s top five constituents are each up handsomely.
It is not our intent in this brief commentary to analyze the fundamentals or valuations of these stocks, other than to make the naïve observation that all of them ostensibly benefit from the fact that we are working, spending and consuming from home more than usual. It is our intent to point out that the performance of the widely followed S&P 500 index is influenced or even defined lately by the fortunes of a list of stocks that an investor can count on one hand.
What are the implications of such a narrowly led market? First, markets dominated by a small set of companies – particularly when concentrated in a single industry – tend to be volatile. As investor appetite for technology stocks waxes and wanes, these stocks might become the tail that wags the market dog. If a few companies led the market higher, they can lead it lower as well. Second, narrow market leadership means that the relative returns of actively managed portfolios depend largely on exposure to these leaders.
We remain committed to an active approach to identifying and exploiting dislocations between price and value. Our portfolio managers are agnostic toward the way indices are constructed and will not hold a stock – even one with a large index weight – solely in order to manage the volatility of relative returns. Our ultimate objective is to preserve and grow our clients’ wealth, not to play the game of short-term relative performance that narrow leadership makes so very difficult to win.
The Russell 2000 Index is a small-cap stock market index of the bottom 2,000 stocks in the Russell 3000 Index, which is made up of 3,000 of the biggest U.S. stocks.
References to specific securities, asset classes, and financial markets are for illustrative purposes only and are not intended to be, and should not be interpreted as recommendations.
Opinions, forecasts, and discussions about investment strategies represent the author’s views as of the date of this commentary and are subject to change without notice. References to specific securities, asset classes, and financial markets are for illustrative purposes only and are not intended to be, and should not be interpreted as recommendations. Brown Brothers Harriman & Co. (“BBH”) may be used as a generic term to reference the company as a whole and/or its various subsidiaries generally. This material and any products or services may be issued or provided in multiple jurisdictions by duly authorized and regulated subsidiaries. This material is for general information and reference purposes only and does not constitute legal, tax or investment advice and is not intended as an offer to sell, or a solicitation to buy securities, services or investment products. Any reference to tax matters is not intended to be used, and may not be used, for purposes of avoiding penalties under the U.S. Internal Revenue Code, or other applicable tax regimes, or for promotion, marketing or recommendation to third parties. All information has been obtained from sources believed to be reliable, but accuracy is not guaranteed, and reliance should not be placed on the information presented. This material may not be reproduced, copied or transmitted, or any of the content disclosed to third parties, without the permission of BBH. All trademarks and service marks included are the property of BBH or their respective owners. © Brown Brothers Harriman & Co. 2020. All rights reserved. PB-03708-2020-05-26