The Super Six
When you think about how crazy, unsettling and unprecedented this year has been so far, in so many ways, it is truly remarkable that the U.S. stock market, as represented by the S&P 500 Index, is down only 3% for the first six months. That includes, of course, the stomach-wrenching market drop of 34% in a record 33 calendar days between the high on February 19th and the trough on March 23rd.
The top 5 return contributors for the first half of the year were all Large-Cap Growth companies: Amazon, Microsoft, Apple, NVIDIA and PayPal. Together, they added 4.5% to the Index return. If they had each had a zero return instead, the S&P 500 would be down over 7.5%. In fact, over 70% of the stocks in the index had a negative return, down an average of 23% for the year through June.
This illustrates the fact that overall stock market returns are often attributable to just a few very large stocks. For example, since the beginning of 2015 through May 18, 2020, the S&P 500 Index increased in value a little over 60%, but much of that performance was driven by the “Super 6” stocks: Facebook, Apple, Alphabet, Amazon, Netflix, and Microsoft (a.k.a. the FAAANM stocks). What would the index returns look like without them? This is dramatically illustrated by comparing the blue line (FAAANM only) with the red line (S&P 500 without the FAAANM) in this chart:
These six stocks had a total market value of $4.7 trillion on June 30th of this year, representing 21% of the market value of the S&P 500 Index. During that stretch of time since the beginning of 2015, the FAAANMs had an average return of 400%, exhibiting positive momentum and very strong popularity with investors.
Research shows that popular, high-momentum stocks tend to keep that momentum going for a while. Until the music stops, that is. High-flying stocks like these can often “get ahead of their skis,” meaning that they can get overvalued compared to what their fundamentals can reasonably justify. One measure of relative price valuation is the price-to-earnings ratio (PE). The Super 6 currently have an average consensus forward PE ratio of 58 times. The S&P 500 Index, as a whole, has a forward PE of 21.
A well-known period of stock overvaluation was the Tech Bubble, which occurred during the last half of the 1990s. Internet and telecom stock were priced to perfection, until the bubble burst in March of 2000, ending an impressive run of outperformance by growth stocks. (Value stocks then took over market leadership for the next seven years in a row).
A good example of what overvaluation can look like comes from Microsoft’s stock performance, which peaked at the end of the Tech Bubble in 1999. As the following chart shows, it took a total of eighteen years for Microsoft stock to reach the price it achieved during the Tech Bubble.
The returns achieved by popular, high-momentum stocks can become a self-fulfilling prophesy of sorts, as more investors pour money into the high-flyers, the prices go ever higher. This eventually pushes the market values of some of these stocks to the top of the heap, so that today Microsoft, Apple, and Amazon each are valued at or close to $1 trillion.
Owning momentum stocks is a well-established investment strategy, and has its place in some investor portfolios, but it shouldn’t be your only strategy. Yes, larger companies tend to do better during large drawdowns. The Super 6 were down an average of 23% during this year’s 33-day sell-off (Netflix fell only 7% and Amazon 12%). The problem with very large companies is that, as they continue to grow year after year, it becomes harder and harder to maintain that high-growth profile that some investors love so much.
The following chart illustrates this point, showing what happens to the performance of very large U.S. stocks after they become one of the top ten largest. The chart shows that, for the period from 1927 to 2019, five and ten years after they reached the Top Ten, on average, they underperform the general market.
The bottom line is that the desire to chase returns historically provided by popular growth stocks is an example of what behavioral economists call a cognitive bias. Like overconfidence, such biases trick us into thinking we are acting in our best interest, when, in fact, they may cause us to do things with our money that are not in our best long-term interest.
Remember that, unless you were smart (or lucky) enough to have owned the Super 6 back in 2015, all that wonderful, impressive performance we read about earlier was enjoyed by someone else, and that past performance is no guarantee of future similar results. A more balanced, diversified investment approach will, in the long run, better help clients achieve their financial goals, with less volatility.
John serves as Chief Investment Officer for Coyle Financial Counsel and is responsible for overseeing the investment process. John’s prior experience includes managing institutional fixed-income portfolios for corporations, pension funds, non-profit organizations and foundations at several large, global asset managers. With more than 20 years of institutional investment experience, he is energized by helping individuals understand the role investing plays in meeting their long-term financial goals.
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 Source: Morningstar Direct, unless otherwise cited
 DoubleLine Funds: MSCI,DataStream, Bloomberg, Minack Investors
 JP Morgan Asset Management, 3Q20 “Guide to the Markets”, as of 6/30/20
 Vitaliy Katsenelson, https://twitter.com/vitaliyk