Yet Another Reason

Adam M. Grossman

I FEEL LIKE A BROKEN record when I talk about the benefits of index funds. Indeed, index fund advocates—myself included—sometimes get a little preachy, so I won’t bore you with the same facts I’ve cited before.

Instead, I want to focus on a more subtle reason to index, which has been highlighted by the stock market’s behavior over the past year. You’ve probably heard the expression “a rising tide lifts all boats.” When it comes to the stock market, this is generally true—but only sort of and only some of the time.

The reality is that the stock market consists of many sectors—everything from technology to health care to energy. In all, the S&P 500 breaks down into 11 different industries. To continue the rising-tide analogy, each of these 11 sectors is like its own small boat. Sometimes they move together, but often not.

As an individual investor, these dynamics are worth understanding. The past 12 months provide a perfect laboratory for seeing them in action. Between early October 2018 and early October 2019, the overall S&P 500 was virtually unchanged. But pull back the curtain to examine each of the 11 industries, and the results have hardly been uniform. In fact, they could hardly have been more different.

What was the best performing industry over the past 12 months? Probably the last one you’d guess: the utilities industry, comprised of electric, gas and water companies. As a group, utilities gained more than 25%. What was the worst? The energy industry, which was down 24%. In other words, there were nearly 50 percentage points separating the best and worst sector. How did the communications sector—home of Google, Netflix and other popular stocks—fare? It was barely positive.

These types of divergences occur all the time, but sometimes they’re greater than others. According to an analysis by Goldman Sachs, stocks moved as a relatively tightly correlated group for many years after the 2008 recession, as the market marched higher. But over the past year, that correlation has broken down. In late September, as the market approached record highs, only 106 individual stocks within the S&P 500 were themselves at record highs.

What explains these divergences? Each industry is driven by its own dynamics. Energy companies often move in virtual lockstep with oil prices. Other industries will move together in response to a big multi-year trend. The growth of smartphones, for example, has lifted the stocks of all companies in that food chain, from manufacturers to component suppliers to owners of cell towers.

Sometimes, groups of stocks will respond to a very specific event. In 2011, the shares of all computer hard drive makers were hit when monsoons swept through Thailand, damaging factories where a large portion of the world’s hard drives are made.

At other times, stock movements have more indirect causes. During 2018’s last three months, when people began to fret about the impact of higher interest rates, the stocks of highflying companies took a steep dive. Netflix dropped 28% in just three months. Where did investors go during that period? Into so-called safe haven stocks like Procter & Gamble, which makes toothpaste, diapers and paper towels—items that people continue buying through good times and bad. That company and its peers tend to do extraordinarily well when people get scared.

Innumerable other factors impact the fortunes of individual industries. These include inflation, regulation and, most recently, tariffs.

There are lots of people on Wall Street who make their living tracking things like oil prices, industrial production and a thousand other economic indicators. But in the end, as recent months have shown, it’s impossible to know where any of these numbers are headed. That’s because so much of what happens in the economy is random, like the flooding in Thailand, or it’s dependent on decisions by policymakers, who themselves probably couldn’t tell you how things will turn out next month or next year.

All of this, in my view, is yet another reason to cast your lot with index funds—and not just any index fund, but total market funds whose broad diversification will help limit the damage when a storm hits any one industry.

Adam M. Grossman’s previous articles include Peter PrinciplesBut Will It Work and Staying Positive. Adam is the founder of Mayport Wealth Management, a fixed-fee financial planning firm in Boston. He’s an advocate of evidence-based investing and is on a mission to lower the cost of investment advice for consumers. Follow Adam on Twitter @AdamMGrossman.

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