News of trade talks between the United States and China helped support a rally in U.S. stocks last week. The talks are scheduled for next week, and officials say the two nations hope to sign a compromise by November.
The Trump administration is considering allowing companies to report earnings twice each year rather than quarterly. The administration says the extra time would allow companies to take a longer-term view. Critics suggest an added three months is unlikely to make a material difference. The proposal may stretch out the holding periods of some investors. Our approach is always focused on the long term; whether earnings are reported quarterly or semi-annually won’t make much difference.
The situation in Turkey improved this week as the Turkish government took some initial steps to shore up its currency but avoided some of the structural reforms many suggest are necessary. Turkey did take small steps to tighten lending while simultaneously providing support for banks. Qatar also announced a $15 billion support package for Turkey.
Most of these measures are likely to buy time for other reforms to be worked out. Turkey had used debt to fund rapid economic growth in order to support the re-election efforts of President Recep Tayyip Erdogan. Part of the push for rapid growth involved heavy government interference in the central bank’s interest rate policies.
It’s important to remember these types of crises are typically worked out and markets rally after the easing of tensions. The chart below shows how the U.S. stock market has reacted as currency crises fade. In the last five cases, stocks have followed a relatively stable increase as investors see the problem contained. While risks remain, this event may prove to be an excellent opportunity to take advantage of a market decline.
MORE ITEMS FROM LAST WEEK.
Some pretty good numbers have been posted for 2018. They’re the type of numbers that inspire confidence. For example:
4.1 percent. The United States experienced strong economic growth during the second quarter. The advance estimate for U.S. gross domestic product (the value of all goods and services produced by a nation) during the second quarter of 2018 was 4.1 percent. That was the highest rate of growth since the first quarter of 2014.
24.6 percent. 2017’s tax reform, which lowered corporate tax rates from an average of 35 percent to an average 21 percent, boosted corporate earnings, reported Nasdaq.com. With 91 percent of companies reporting in, the blended earnings growth rate for the S&P 500 was 24.6 percent during the second quarter of 2018.
$1 trillion. What are companies doing with their tax windfall? U.S. companies are rewarding shareholders by buying back stock, reported Nasdaq.com, which suggested buybacks could total $1 trillion in 2018.
3,453 days. Depending on how precisely you define the last bull market, August 22 may be the day that marks this one as the longest bull market in history.
While positive economic and market numbers are nice to see, they are trees in a forest and don’t necessarily provide a full or an accurate picture. For instance, the length of a bull market is interesting, but it has no predictive value, reported Barron’s. The length of the current economic expansion is far more important.
Barron’s cited Dr. Ed Yardeni, chief investment strategist at Yardeni Research, who said, “All I’m interested in is how long the expansion lasts…Because the longer it lasts, the longer the bull market lasts.”
It’s important to understand which numbers are important and how they relate to one another.
It can be very easy to forget that the stock market is a market of thousands of individual stocks doing their own thing. While major averages like the S&P 500 are helpful and can give a rough idea of how the overall market is behaving, they also have some limitations due to the way they are constructed.
The Dow Jones Industrial Average, for example, is price-weighted, so stocks with a higher price have more of an impact on the performance of the index than stocks with a lower price (which doesn’t really make much sense, in our opinion). Meanwhile, the S&P 500 is market-cap-weighted, which makes more intuitive sense than a price-weighted index like the Dow, but it also means that the biggest stocks in the market are always going to have a disproportionate impact on what happens with the index itself (that’s just the way math works).
Due to this effect, a lot has been made recently of the fact that only a handful of stocks are responsible for the majority of the S&P 500’s gains so far this year. And yes, this is a fact, as the data below show, but the danger here is that too many people seem to be misinterpreting the information as this has been a narrow market or that only a handful of stocks have been going up, which is not the case at all.
As of last week, six stocks in the S&P 500 – Netflix, Amazon, Microsoft, Apple, Alphabet, and Facebook – had collectively contributed approximately 5% of the S&P 500’s 6.2% price return year-to-date, or about 80% of the returns overall. At first, this sounds concerning or intimidating and might lead one to believe that we’re secretly in a bear market that no one told these six companies about. Yet, once again, this phenomenon says much more about the way the S&P 500 is constructed than it does about the breadth or health of the stock market.
The six aforementioned stocks also happen to be five of the six largest companies in the market by market cap, with Netflix a still significant 35th in market weight. If these stocks have a good year, as they mostly have so far in 2018, it should come as no surprise that they are having a significant effect on cap-weighted indices like the S&P 500. It’s like being surprised that the 3-4-5 hitters in a baseball lineup are driving in a disproportionate number of runs!
What follows is a breakdown of the “big six” stocks by both 2018 year-to-date price performance within the S&P 500 and their current market cap (as of mid-last week):
- Netflix (NFLX): 3rd in performance; 35th in market cap
- Amazon (AMZN): 6th in performance; 2nd in market cap
- Microsoft (MSFT): 56th in performance; 4th in market cap
- Apple (AAPL): 72nd in performance; 1st in market cap
- Alphabet (Google) (GOOG): 104th in performance; 3rd in market cap
- Facebook (FB): 254th in performance; 5th in market cap
What jumps out initially is that, other than Netflix and Amazon, the rest of these stocks haven’t performed as great as most probably believe when considering that, collectively, they are responsible for 82% of the S&P 500’sperformance this year. The latter four aren’t even in the top 10% of S&P 500 stocks, return-wise, and Facebook is actually underperforming the S&P 500 by a fair margin.
Contrast these return numbers with the six best-performing stocks in the S&P 500 so far this year (other than Netflix and Amazon) and their respective market caps:
- Abiomed Inc. (ABMD): 1st in performance; 310th in market cap
- Advanced Micro Devices (AMD): 2nd in performance; 292nd in market cap
- Chipotle Mexican Grill (CMG): 4th in performance; 372nd in market cap
- Align Tech Inc. (ALGN): 5th in performance; 193rd in market cap
- Macy’s Inc. (M): 7th in performance; 395th in market cap
- XL Capital Ltd. (XL): 8th in performance; 350th in market cap
Only ALGN is even in the upper half of the S&P 500 based on market cap, which means that these companies are not going to have a major impact on the index itself despite all returning a minimum of 60% year-to-date.
Notably, these six top performers, when added together, are only contributing 0.30 total percentage points to the S&P 500’s 6.21% return so far in 2018, just 4.86% of the overall price return (again, compared to the 5.09 percentage points and 82% of the overall return for which the “big six” are responsible). Just for kicks, if these six best performing stocks had the same market weights as the “big six” stocks currently do (in order of performance), they’d collectively contribute 11.97 percentage points compared to the “big six’s” 5.09, which again shows the impact of company size on these cap-weighted averages.
Yet, it’s not until we look at the impacts of some of the individual stocks that the importance of market weight becomes even more apparent. For instance, Facebook (to repeat), is actually underperforming the S&P 500 so far this year with a return of 2.35% as of yesterday afternoon, but it is currently contributing MORE to the S&P 500’s price performance due to its size than Chipotle, Macy’s, or XL Capital, which are up 69.8%, 63.80%, and 60.47%, respectively.
The contribution disparity even emerges from within the “big six” itself: Alphabet has had a good year so far, up 18%, but Netflix has done more than four times better with a return above 76%; however, because Alphabet represents a little more than 3% of the S&P 500’s weight while Netflix is only approximately 0.6% of the S&P 500, Alphabet has actually contributed more to the index’s returns in 2018 despite far inferior performance.
The point here is that while a handful of stocks are definitely having a disproportionate effect on the S&P 500, it does not mean that these are the only stocks doing well or that it’s even a reason to be confused. It is what it is. The largest stocks in the market have mostly performed well this year so it’s helping to boost up the index. What it does mean is that if you’re judging portfolio performance against the S&P 500 but don’t have similar weights to the stocks in the S&P 500, your performance can vary greatly (for better or worse).
It also means that the S&P 500 itself generally goes wherever its biggest stocks go, which is something we have written about before. To get a significant decline in the S&P 500, the mega cap stocks almost have to participate in that decline too. Contrary to what many people believe, though, the biggest stocks in the market today aren’t even having as great of an impact on the S&P 500 as the biggest stocks in the index have had historically.
A recent study on the subject that showed the largest five companies in the S&P 500 currently account for 13.98% of the total index, which is actually lower than the average of 14.33% since 1972. This metric was above 20% for most of the 1970s and topped out above 18% around the Dot-Com bubble.
Moreover, it’s nothing new to have a small number of stocks contribute to the bulk of the S&P 500’s gains. As research from AQR’s Cliff Asness shows, the S&P 500 returned 9.3% a year from 1994-2014 and the top 20 stocks in the index each year accounted for 6.3 of those percentage points, on average, or around 68% of the total performance.
To conclude, we don’t think the stock market has been as narrow as many headlines have made it out to be recently. Market breadth hasn’t exactly been outstanding for much of this year and it has contracted recently (which is something we’re watching), but more stocks have still risen in 2018 than have fallen. About a third of the S&P 500 is up more than 10% year-to-date, as well, and overall, we think both the breadth readings and the performance of the indices are what we’d expect during a multi-month consolidation like we’ve had since late January.
It’s worth noting, too, that the equal-weight S&P 500, which isn’t skewed by the largest companies, is still up 4% on the year and the small cap indices like the Russell 2000 have outperformed the S&P 500 so far in 2018. There have been plenty of opportunities within the stock market, but you just have to look a little harder than you did in 2016 or 2017 to find them.
Key points for the week
- China and the United States have scheduled trade talks in hopes of reaching a compromise.
- Turkey’s government made minor, positive steps to support its currency, but risks remain elevated.
- The Trump administration wants to examine whether companies should report earnings every six months rather than quarterly.
What are we reading?
Below are some articles we paid particularly close attention to this week. We encourage our readers to follow the links.
Residents in a Toronto neighborhood were fed up with an ever-expanding sinkhole, so they decided to stage a healthy protest by growing tomatoes in it. Once the story hit the local news, the city finally came around to fixing the sinkhole. Meanwhile, the tomato plants were not forgotten – they were transferred to a community garden.
Those heading into retirement should be looking at the period of time after ending full-time work and before you begin taking required minimum distributions from retirement plans.
“There is no truth. There is only perception.”
~ Gustave Flaubert, French novelist
“It is the working man who is the happy man. It is the idle man who is the miserable man.”
~ Benjamin Franklin
“The most delightful surprise in life is to suddenly recognize your own worth.”
~ Maxwell Maltz, Surgeon
“Begin to free yourself at once by doing all that is possible with the means you have, and as you proceed in this spirit the way will open for you to do more.”
~ Robert Collier, Writer & Publisher
Links & Disclaimers
RJFS and SPC do not offer or provide legal or tax advice. Tax services and analysis are provided by the related firm, S&M through a separate engagement letter with clients. Portions of this newsletter were prepared by Carson Group Coaching. Carson Group Coaching is not affiliated with RJFS, SPC or S&M. The information contained in this report does not purport to be a complete description of the securities, markets, or developments referred to in this material. The information has been obtained from sources considered to be reliable, but we do not guarantee that the foregoing material is accurate or complete. Any information is not a complete summary or statement of all available data necessary for making an investment decision and does not constitute a recommendation. This information is not intended as a solicitation of an offer to buy, hold or sell any security referred to herein. There is no assurance any of the trends mentioned will continue in the future. Any opinions are those of the author and not necessarily those of RJFS. Any expression of opinion is as of this date and is subject to change without notice.
Opinions expressed are not intended as investment advice or to predict future performance. Economic forecasts set forth may not develop as predicted and there can be no guarantee that strategies promoted will be successful. Past performance does not guarantee future results. Investing involves risk, including loss of principal. Consult your financial professional before making any investment decision. Stock investing involves risk including loss of principal. The S&P 500 is an unmanaged index of 500 widely held stocks that is generally considered representative of the U.S. stock market. The Dow Jones Industrial Average (DJIA), commonly known as “The Dow” is an index representing 30 stock companies maintained and reviewed by the editors of the Wall Street Journal. Please note direct investment in any index is not possible.
The Russell 2000 Index measures the performance of the 2,000 smallest companies in the Russell 3000 Index, which represent approximately 8% of the total market capitalization of the Russell 3000 Index.
Raymond James makes a market in NFLX, AMZN, MSFT, AAPL, GOOG, FB, ABMD, AMD, CMG, ALGN, M, and XL.
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