By: Steve Smith
The headlines are filled with talks of tariffs, Russia and rates. Oh, and earnings are about to come gushing through our streaming screens. But what has quietly becoming disconcerting to some of even the verdant bulls (investor sentiment just hit highest level in 5 months) is what seems to be narrowness of the market. Today’s investing advice will explain the dangers of this lack of diversity.
Namely, that the top 5-6 issues, guess who (FAAMNG) account for some 85% to 95% of the market gains this year.
But this stat is misleading, and is strictly a result of the way cap weighted indexes get calculated.
The obvious takeaway here would seem to be that 2018 market returns (around 5% for the S&P and 14% for the Nasdaq 100) are all being driven by a handful of names. And if that handful of stocks ever come back down to earth, which they’ve been wont to do on occasion, then look out below.
The simplest explanation for these staggering numbers is the fact that this is how market capitalization weighted indexes work. By definition, the largest stocks will have a bigger impact on the returns than the smaller stocks.
But when you have the Russell 2000 small cap not only hitting new highs, but actually outperforming the SPX and NDX that shows plenty of other stocks are doing well too.
Indeed, look at how overall NYSE Advance/Decline line tracks SPX. No divergence or thinness here.
Does it concern me that handful of top companies are doubling their market cap and are more than equal to bottom 85% of the market on a near quarterly basis. Sure. But it’s always been this way.
And the reasons have some legitimate explanations, and there are plenty of other stocks racking up big gains. I’ll get more worried when the market gets too fat.
From a simple TA standpoint the SPX/SPY needs to clear the 2800/$280 level.
Yes, tech stocks are the big winners. No, this won’t last forever. But it’s also true that financial or energy stocks at the top of the market won’t be laggards forever either. It’s quite possible that they can offset some of the relative losses when we do finally see a mean reversion in technology.
Here are a few takeaways to wrap things up on this topic:
If you’re invested solely in a total market or S&P 500 index fund, then yes, your returns will likely be driven by a handful of stocks. This is simply the way market cap weighting works, for better or worse.
If you’re diversified outside of the market cap weighted indexes, that means your returns are going to look different at times. Going lower on the cap-weighted spectrum has been a net positive this year. Last year large caps outperformed micro, small and mid caps. So it goes when diversifying.
The concentration of returns in the stock market is one of the most underrated reasons for diversifying your investments. No one knows where the huge gainers will come from each year or over the long run. Diversifying gives you a chance to allow the outlier winners to overshadow the outlier losers.
None of this data I’ve presented here means the stock market can’t fall from here. We certainly could see what many would call an overdue correction in tech stocks that brings down the rest of the market with it. Or investors could get spooked by something else which could send micro caps, small caps, mid caps and mega caps all reeling.
But the stock market is not currently being driven by just a handful of stocks. In fact, the fact that smaller companies are outperforming this year is a tell-tale sign that this isn’t the case. Whether it lasts or not, this is a full-fledged market rally where every capitalization size is taking part in the gains.