May 26, 2020
Is a Return to a More Rational Market on the Horizon?
Anticipating the Return to a More Rational Market
The COVID-19 crisis may have ushered in what could be the most rapid market downturn that we experience in our lifetimes. Market concentration and a disregard for fundamentals, however, had already emerged as indicators of an unhealthy late stage bull market— before the pandemic triggered the selloff starting in mid-February. Investors continue to exhibit some of this seemingly irrational behavior today. Despite the rapid correction, we believe the market is overdue for a return to a mindset that rewards attractive fundamentals and valuations to allow broader participation in market rallies1.
An Increasingly Concentrated Market
In many ways, market dynamics until early February 2020 looked very much like conditions in 1999 before the start of the tech bubble downturn. Many thought the long-running bull market would never see such a significant fall again despite warning signs.
During the past several years, the capital markets have been dominated by macro issues which have driven investor behavior. Trends such as ongoing adoption of e-commerce; efficiencies and new business models enabled by cloud-based systems; and lower interest rates have created a gold-rush mentality among investors, who have rewarded mega stocks such as Amazon, Apple and Microsoft.
Since January 2018, although the average stock in the Russell 1000 Index fell more than 7 percent on an annualized basis, the largest technology and internet stocks had strong positive returns. Amazon, Apple and Microsoft all gained more than 20 percent on an annualized basis. Excluding these three stocks, the S&P 500 and Russell 1000 indexes would have had negative returns during this period, as shown in Exhibit 1. This narrow set of stocks has driven the rise of the major indexes in recent years.
As stock market performance became increasingly concentrated in this small number of the largest technology and internet-related names, the benchmark indexes have become increasingly top heavy. Five companies (Alphabet, Amazon, Apple, Facebook, and Microsoft) account for approximately 20 percent of the overall weighting in the S&P 500 Index, and the concentration has reached similar levels in the Russell 1000 Index, as shown in Exhibit 2. The same five companies in the Russell 1000 Growth Index are even more concentrated at nearly 32 percent.
A Difficult Search for Alpha
This context has been challenging for equal weighted portfolios and stock selection strategies.
For the 12 months ending March 31, 2020, the average stock in the Russell 1000 Index had a total return of approximately -20.9 percent and underperformed the cap-weighted index by about -12.8 percent, as the chart in Exhibit 3 illustrates. This result is the most negative relative performance since the 12-months ending April 1999.
Over the past 27 months, the average stock (equal-weighted) in the Russell 1000 Index has underperformed the cap-weighted index by about 7.4 percent. Where only a small percentage of stocks beat the index, an equal weighted portfolio would not be likely to outperform. It has been difficult for many stock selection strategies to outperform during the past two to three years as less than one-third of large cap stocks have outperformed the Russell 1000 Index, as shown in Exhibit 4.
Is a Return to an “Old Normal” on the Horizon?
There are a number of factors that give us confidence that performance trends will reverse and ultimately gravity will prevail. Typically, the largest stocks that have outperformed are subject to diminishing future returns due to size and increased regulatory scrutiny. These shifts can be seen when considering the rate of turnover of the top ten largest constituents in the S&P 500 Index, which has been approximately 17 percent versus about 6 percent for the overall index (since 1993).
Going forward, as the world manages through the COVID-19 pandemic and investors reassess the role of fundamentals, we expect a normalization of economic growth and the capital markets. Three historical trends inform our perspective:
1. The average stock tends to outperform cap-weighed indexes over time.
Since 1958, the average stock (equal-weighted) in the S&P 500 Index has outperformed the cap-weighted index by an annualized 2.4 percent, creating an environment for equal-weighted portfolio construction to add to performance. On a cumulative basis, a dollar invested in an equal-weighted portfolio of S&P 500 constituents on January 1, 1958, would have grown by December 31, 2019 to $679 versus $157 for the cap-weighted index, as shown in Exhibit 5.
2.Today’s leaders tend to become tomorrow’s laggards.
Since 1984 through March 31, 2020, when S&P 500 Index concentration in five companies reached more than 14 percent, those top five companies went on to underperform the index on average by more than 5 percent annualized in the subsequent 3 years. See Exhibit 6.
3. Equal weighted and inexpensive stocks have typically outperformed following a bear market bottom.
The results from analyzing Fama French data since July 1926 in Exhibit 7 show that U.S. stocks (NYSE, AMEX and NASDAQ) achieved on average nearly 37 percent returns in the 12 months after the bottom of a bear market has been reached. During those post-drawdown periods, incrementally, stocks biased towards value and small size factors outperformed by approximately 11 percent and 10 percent, respectively. The value and size excess returns in Exhibit 7 are based on the annualized average spread between the performance of the top and bottom quintiles for all U.S. listed equities on a market-cap weighted basis.
Anticipating Revival of Rationality
The intensifying market concentration in recent years has made the search for alpha in the large cap market significantly more difficult. Certain macro trends have eclipsed business fundamentals as drivers of investment decisions, and a small set of the largest stocks have primarily driven index performance as a result. We believe a return to more historic norms for performance drivers is on the horizon given the patterns we have seen in the data from past decades. As investors re-evaluate their investment strategies in today’s uncertain world, a more rational consideration of business fundamentals and value factors to inform decision making should prevail.
1The approach throughout the paper is to use the maximum amount of data possible for analysis. As a result, starting dates for various exhibits may differ due to availability of data from a particular source. For example, monthly returns for Fama French factors begin in July 1926 while FactSet’s pricing database starts in 1984.
The views expressed represent the opinions of the portfolio managers as of March 31, 2020. Information included was gathered in good faith from sources presumed to be accurate, but accuracy is not guaranteed. Past performance may not be indicative of future results. This paper represents the view of its authors as of the date it was produced, and may change without notice. There can be no assurance that the same factors would result in the same decisions being made in the future. In addition, the views are not intended as a recommendation of any security, sector or product. Returns reported represent past performance and are not indicative of future results. Actual performance may be lower or higher than the performance set forth above. For institutional adviser use only, not intended to be shared with retail clients. The S&P 500 Index is a broad-based unmanaged index of 500 stocks, which is widely recognized as a representative of the equity market in general. The Russell 1000 Index is an unmanaged, market-capitalization-weighted total return index comprised of the largest 1,000 companies in the Russell 3000 Index. This unmanaged index is a total return index with dividends reinvested. The Russell 1000 Growth Index is an unmanaged, market-capitalization-weighted total return index comprised of securities in the Russell 1000 Index with greater than average growth orientation. This unmanaged index is a total return index with dividends reinvested. One cannot invest directly in an index.