The US economy has surprised on the upside in 2017, with growth remaining strong despite the policy paralysis within the Trump administration. This has been reflected in the performance of the S&P 500 Index, which is up 16.9% year-to-date (YTD) in US dollar terms. However, underneath this headline figure, there is significant distortion within the US equity market.
Much is written about the ‘FANG’ stocks (Facebook, Amazon, Netflix & Google) but it is actually Apple, Alphabet (Google’s parent company), Amazon, Facebook and Microsoft that are amongst the largest 10 stocks in the benchmark. These companies are investor favourites and, in aggregate, they are holding up the US equity market in 2017. This is because underneath the 16.9% total return figure, the market is more in turmoil than many investors think. These stocks have been one of the few parts of the market to have worked this year, which has encouraged many to follow the herd. However, given they now form such a large part of the Index, we believe this is very dangerous as history shows they cannot keep going up forever. But how have we come to this conclusion?
Apple, Alphabet, Amazon, Facebook and Microsoft (AAAFM) are collectively worth 14% of the S&P 500 Index. They have also continued to perform strongly in 2017 so far, returning 41.4% on a market-cap average weighted basis. This implies that they are responsible for 34% of the S&P’s entire total return in 2017 so far. Therefore, excluding these names would have seen the benchmark returning just 11.1% YTD. This type of performance concentration is not healthy, nor is it historically sustainable. On the counter side, 134 stocks in the Index have delivered a negative return in 2017. This is because investors are paying a premium for AAAFM names, whilst punishing the rest of the market if consensus earnings expectations are met, or in some cases even exceeded. These high growth names are in vogue, Amazon trades at a price-to-earnings (P/E) ratio of 289x, whilst the other four trade at 29x on average. They cannot keep going up for ever.
What does history tell us?
In short, this market-cap, valuation-dominated performance is not normal. To highlight this, we can analyse the performance of the S&P 500 Equal Weighted Index, which equalises the weight of all constituents, paying no regard to market value. Since 1990, when the data began, this index has outperformed its more common market-cap weighted compatriot 61% of the time on an annual basis. Indeed, compounded over the entire period, this has translated into significant long-term cumulative outperformance.
Significant long-term outperformance
Source: Morningstar Direct, 31/12/89 to 31/12/16. Performance shown in US dollars. Past performance is not a guide to future performance.
Historically, this is typical of most equity markets as the performance of potentially faster growing companies further down the market-cap spectrum is given an equal weighting alongside the mega-cap behemoths. However, the S&P 500 Index has outperformed its equal-weighted counterpart over the last four years and a marked acceleration is visible in 2017 year-to-date. This has been due to the AAAFM affect.
The trend has reversed
Source: Morningstar Direct, as at 31/10/17. Performance shown in US dollars. Past performance is not a guide to future performance.
What are the risks?
This concerns us, as it is never a good sign that a stockmarket is being driven by a highly concentrated group of stocks. For example, back in 1999, the S&P 500 outperformed the Equal-Weighted Index by 10%. In the following two years – amidst the dotcom crash – the Equal Weighted Index returned 18.3% in 2000, 2.2% in 2001 and -26.0% in 2002. In contrast, the market-cap weighted S&P 500 posted returns of -1.9%, -9.6% and -29.6%.
With the global economy now enjoying a synchronised recovery and bond yields edging higher, the valuations of these kinds of stocks could come under some pressure, whilst any earnings disappointments are likely to be severely punished by the market. Although all are excellent companies, we believe valuations and sentiment have been driven to extremes, whilst the rest of the market has been left behind. They cannot keep going up in such a way forever and, whilst timing the exact end of the AAAFM cycle is nigh on impossible, we remain confident that our more diversified, value-orientated portfolio is well-positioned for 2018 and beyond.
Source: All performance figures obtained from Morningstar Direct, in US dollars.
Past performance is not a guide to future performance. The value of investments may fall as well as rise and investors may not get back the amount invested. Income from investments may fluctuate. Currency fluctuations can also affect performance.
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