A few weeks back, I noted how the stock market had become unusually top-heavy, with just five companies—Amazon, Apple, Facebook, Google and Microsoft—accounting for 20% of the overall value of the S&P 500. But a chart that appeared online this week illustrates the impact of that imbalance. What it shows, in a nutshell, is that the overall S&P 500 is in positive territory for the year, but only because of those top five stocks. So far this year, those five have collectively gained 35%. But the other 495 stocks in the index? As a group, they have lost money—down about 5%. In other words, the impact of those five is so outsized that they more than offset the other 495 combined, swinging the overall average from a loss to a gain.
It’s one simple chart, but I think there’s a lot to learn from it:
Explaining the inexplicable – The chart helps explain the stock market’s seemingly inexplicable rebound since March. After dropping 35% in the early days of Covid, the S&P 500 staged a quick recovery and has since rallied 44%. Many—if not most—stock market observers have been scratching their heads over this. With the economy in recession, thousands of companies shut down, and millions out of work, how is it that the stock market has nearly reclaimed its prior all-time high? This chart helps explain what’s going on. The reality is that most stock prices are in tough shape and very much reflect the reality of the ongoing pandemic. As of this morning, more than 300 of the 500 stocks in the S&P 500 are down this year—some very significantly: Banks are down 20%, energy stocks are down 35%, and travel-related stocks are faring even worse. Marriott is down 42%, American Airlines is down 60% and Norwegian Cruise Lines is down 75%. Through this lens, the market rebound is less irrational than it appears. Don’t get me wrong: The massive popularity of those top five (along with Tesla, which isn’t yet in the S&P 500) still concerns me. But they’re just part of the story. Many other stocks do provide a more level-headed reflection of the state of the economy.
Confirming the counter-intuitive – A while back I mentioned the results of a study by Hendrik Bessembinder that seemed hard to believe: Throughout history, he concluded, most stocks have been duds. Over time, in fact, more stocks have delivered negative returns than positive. Just 4% of all stocks—a tiny fraction—have accounted for all of the stock market’s gains. When I first saw this, I found it hard to believe. But this year’s market, driven by those top five, helps validate Bessembinder’s findings. The surprising reality is that stocks, on average, are not such a good investment—but some stocks are great investments.
This is why I’m such a strong believer in index fund investing. The fact is, in any given year, random events impact companies’ fortunes—some positively and some negatively. This year is just an exaggerated illustration of that fact. And no amount of stock-picking expertise can change that—because no amount of research or spreadsheet analysis will enable a stock-picker to foresee the future. And, in the absence of being able to know the future, the best defense, in my view, is simply diversification. And the easiest, most cost-effective way to achieve diversification is by buying the index. Sure, that means that you’ll own plenty of stocks that end up as duds—but it also ensures that you don’t miss out on the fraction that turn into stars.
Debunking the “rules” – This year’s unusual market also illustrates why rules of thumb should never be viewed as immutable gospel. When the pandemic hit earlier this year, conventional wisdom was that traditionally “defensive” stocks—such as Procter & Gamble, Clorox or General Mills—would provide investors with a safe haven. That’s because consumers tend to keep buying basics like paper towel, toothpaste and cereal regardless of the economic environment. That’s definitely what happened in the last recession. Between late-2007 and early-2009, when the overall market declined more than 50%, these stocks declined just 30%. But this time, it’s been the opposite. While defensive stocks have certainly done better than hotels and airlines, they have, as a group, lagged the overall market. Meanwhile, the traditionally riskier stocks of high-growth tech companies now seem to be the new safe havens. In short, the traditional rule of thumb has been completely turned on its head.
The lesson: The stock market doesn’t follow a predictable playbook. And even when it does appear to follow a pattern, that pattern is subject to change without notice. As a result—for better or worse—efforts to outsmart the market often turn into exercises in frustration. In my view, though, this is actually a benefit: It means that you don’t need to spend much time, if any, trying to stay ahead of the market. Investment legend Peter Lynch said it best: “I think if you spent over 13 minutes a year on economics, you’ve wasted over 10 minutes. I mean, it’s not helpful. Everybody wants to predict the future, and I’ve tried to call the 1-800 psychic hotlines. It hasn’t helped. The only thing I would look at is what’s happening right now.”
King Solomon once wrote that “there is no new thing under the sun.” This certainly applies to the stock market. Sure, every year is unique in its own way. But at the same time, every time the stock market takes a new twist or turn, it seems to just reconfirm the same set of core principles: Keep things simple, keep costs low, don’t trade too much, don’t put faith in market seers—and diversify, diversify, diversify.