With less than a dozen trading days left in 2015, it’s anybody’s guess as to whether the market will end the year with a positive or negative return. At the market close on December 14, the S&P 500 stood at 2,004, down 1.8% year to date. When dividends are included to arrive at a measure of total return, the market is up a scant 0.2%, leaving plenty of opportunity for the index to push into positive territory, or fall deeper into the negative, before the ball drops in Times Square on New Year’s Eve.
Behind this modest performance for the year, however, lies a great deal of volatility. The S&P 500 Index hit a high of 2,131 on May 21, before dropping 14% over the course of the late summer to bottom at 1,868 on August 25. From that nadir the market rallied to recover two-thirds of that lost ground, standing now within about 5% of its 52-week high.
2015 marks the seventh year of a bull market, and the ability of equities to rebound from their summer lows might be interpreted as a healthy sign of resilience. However, when we look beyond the headline index figure to the performance of stocks within the index, a different picture emerges. Although the index is within a few percentage points of its high for the year, very few individual stocks are. The best performing stocks within the index are some of the largest capitalization stocks in the index, and that has the effect of pushing the index higher.
Capitalization-weighted performance year to date is the modest index drop of 1.8% to which we’ve already referred. On an equal-weighted basis, however, the market is down 5.8% so far this year, demonstrating the degree to which larger companies are supporting the performance of the index.
To be specific, a handful of larger capitalization stocks – including Microsoft, General Electric, Johnson & Johnson, Coca-Cola, Visa and Home Depot – are within a few percentage points of all-time high levels and are providing the support to keep the overall index level up. Conversely, over 40% of the stocks within the S&P 500 – 206 companies out of the 500 members of the index – are trading 20% or more below their 52-week high. If we adopt that 20% figure as a rough definition of a bear market, then a stealth bear market is already underway for a significant fraction of the marketplace.
The nearby graph illustrates this dynamic by ordering each of the 500 companies in the S&P 500 Index by how close its current stock price is to its own 52-week high. Each of the bars in the graph represents a single company in the index, and the index itself is highlighted in red. The index is rather close to the left-hand side of the graph, whereas the majority of the constituents are performing more poorly, and 206 companies are 20% or more below their one-year high-water mark.
More seasoned readers or students of market history might hear in this observation an echo of the “Nifty Fifty” of the early 1970s, a period in which about 50 stocks dominated the performance of the index, and not coincidentally traded at around 50 times earnings. If anything, the current market environment is even more concentrated, although the valuations of the leading stocks today aren’t as inflated as their predecessors of 45 years ago.
This observation holds both bad and good news. The bad news is that the market is narrowly supported by a small handful of names, with the implication that weakness in those stocks would be readily reflected in poorer performance of the overall index. This narrow leadership is even more worrisome in an environment of stagnant earnings growth and full valuations.
The good news is that active investors need not accept the risks posed by the overall market, but can, through careful stock selection, identify companies that offer an attractive tradeoff of risk and return. With more than 40% of the constituents of the index in bear market territory, value opportunities exist.
This deviation of market performance also serves as a reminder of the varying (and sometimes conflicting) definitions of risk that pervade Wall Street. Most institutional investment managers respond to rising risk by diversifying – yet to diversify in the current environment is simply to embrace the risk posed by a narrowly led index challenged by waning earnings and full valuations. Rather than diversify for the sake of diversification, we would rather concentrate into those companies that offer compelling fundamentals and attractive valuations. Good risk management, in our opinion, requires concentration when earnings decelerate and valuations rise.
The overall market environment is challenging, and likely to remain so as we enter 2016. We are reminded of Warren Buffett’s admonition that “the less prudence with which others conduct their affairs, the greater the prudence with which we should conduct our own affairs.” This market calls for prudence.
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