The major equity indexes can be quirky. They are intended to reflect the performance of “the market,” a broad and diverse group of stocks, and they often do. But lately some U.S. indexes haven’t mirrored the performance of the overwhelming majority of their stocks.
Take the S&P 500, for example. It’s widely considered the benchmark or representative U.S. market index due to its composition of large-capitalization stocks, diversified across 11 sectors and numerous sub-industries.
So far in 2020 and for the past year, a handful of the largest stocks within the S&P 500 have far outpaced the index as a whole. Take these giants out of the index, and it’s easy to see there is a chasm between the “haves” and “have-nots”:
- The S&P 500 has risen 9.8 percent in the past 12 months (period ending July 31, 2020). This is a healthy return, about two percentage points above the long-term annual average stretching back almost 100 years, excluding dividends.
- But the five largest stocks by market value (capitalization) represent almost all of the index’s gains. These tech-oriented stocks have surged 58.1 percent during the same 12-month period: Apple, Microsoft, Amazon, Alphabet (Google), and Facebook.
- When these tech giants are stripped out of the index, the remaining stocks in the S&P 500 have risen only 0.6 percent collectively, according to a study by our national research correspondent.
The five largest stocks have dominated S&P 500 returns
Price return in the past 12 months
Source - National research correspondent, RBC Wealth Management, Thomson Financial, FactSet, Bloomberg; data through 7/31/20
Not a tech bubble redux
This mismatch is concerning to us because the outsized influence of the five largest stocks on the S&P 500, and that of the next largest 20 stocks, is similar to what occurred during the tech bubble roughly 20 years ago.
The five largest stocks make up 22.6 percent of the S&P 500’s market capitalization. That’s notably above the 18.0 percent level at the peak of the tech bubble, as the top chart shows. The top 25 stocks represent almost as much of the S&P 500 as they did back then.
Market concentration today is comparable to the tech bubble era
Percentage of market capitalization (weight) in the S&P 500
Source - National research correspondent, Thomson Financial, FactSet, RBC Wealth Management; data represents 3-month moving average for both periods, current data as of 7/31/20
But we don’t think this is the tech bubble 2.0. There are some key differences between then and now.
First, the five largest stocks are less expensive. Today they trade at an elevated price-to-earnings (P/E) ratio of 34.3x based on the forward 12-months consensus earnings forecast. At the height of the tech bubble, the five largest stocks traded at an unseemly P/E ratio of 46.9x. Today’s tech giants are also less expensive on other valuation metrics, including net debt-to-EBITDA.
Second, the large mismatch in stock performance seems justified to us based on earnings trends. In the last 12 months, which includes the difficult COVID-19 collapse in earnings, the tech giants have grown earnings by 6.0 percent, while the rest of the S&P 500 has experienced a 13.1 percent decline in earnings, according to our national research correspondent.
Third, there is also a big disparity in profit margins. Net margins have risen 17.5 percent for the five tech giants compared to 10.2 percent for the rest of the S&P 500, on a trailing 12-month basis.
The largest 5 stocks are less expensive than during the tech bubble era
Price-to-earnings divided by growth rate (PEG ratio) based on next 12 months consensus earnings forecast
Price-to-earnings ratio based on next 12 months consensus earnings forecast
Source - National research correspondent, Thomson Financial, FactSet; current data as of 7/31/20
As we’ve written previously, it’s not unusual for a handful of stocks to get hot for periods of time. We think mismatches in performance between the largest contributors to S&P 500 gains and diversified portfolios will largely sort themselves out over the medium and long term.
It’s notable that among the five largest stocks during the height of the tech bubble—Microsoft, Cisco Systems, General Electric, Intel, and Exxon Mobil—only one is among the five largest stocks today: Microsoft. And even that stock went through a difficult stretch for more than 10 years after the tech bubble burst.
S&P 500 leadership changes over time, which reinforces our longstanding view that it’s prudent to hold diversified portfolios. Until shifts in leadership occur, patience is required.