Chart of the Month – May 2020
Many have been surprised by the strength of the initial recovery in the U.S. stock market, but closer inspection suggests that the recovery is not widespread and is dominated by the recovery in key technology companies. Companies can become popular with investors for a variety of reasons and as the share prices increase, these companies also tend to take a dominant position in the market cap weighted indices.
Perhaps this recent surge in popularity is not so surprising given the importance of these companies during the COVID-19 lockdowns and their already notable weights in the S&P500. The top five stocks (Microsoft, Apple, Amazon, Alphabet (Google) and Facebook) make up 18.35% of the total index. These companies have on average outperformed the S&P500 Index by 22% during 2020. This leads many investors to plunge into these momentum driven holdings, but is that wise?
This is not the first time that a small number of companies have come to dominate a major index. What guidance can we get from these historical experiences? Prior to the “DotCom crash” in early 2000, the top five stocks amounted to 16.6% of the index. The five stocks that were the culprit at that time were Microsoft, General Electric, Cisco Systems, Wal-Mart and Exxon. Only Microsoft remains in a dominant position today. In the following 5 years, four of the five dominant stocks drifted lower, with the average decline being 24%, with only Exxon bucking the trend.
Prior to that, there was the bear market in 1982 which was preceded by IBM, AT&T, Exxon, GE and GM dominating the market and accounting for 22% of the market capitalization of the S&P 500. Most of those stocks remain powerful companies today. In the 5 years (1982 – 1986 inclusive), four of the five companies continued to turn in strong performance (we were unable to find data for the full period for AT&T) but underperformed the index. On average, the shares gained 105% over the following five years, but the S&P500 gained an even more impressive 170%.
The most notable domination of the market by five stocks was in the days of the Nifty-Fifty. Just before the market crashed mightily in 1968, the five stocks in play had 24.5% of the market capitalization. These companies were Walt Disney, Avon, Xerox, Polaroid and Burroughs, of which, only Disney remains a significant business. As with today’s top five, the Price/Earnings Ratios of these stocks were ridiculously high. All were over 48 times earnings, with Polaroid and Walt Disney at 90 times and 82 times respectively. Disney’s share price dropped 82% and did recover, whereas, the others eventually fell out of favour and never returned.
What does this tell us for today’s hottest stocks? Academic literature consistently suggests that jumping on board with “popular” stocks has historically led to underperformance. Experience suggests the same.
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