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Skewed Impression

Adam M. Grossman  |  July 26, 2020

THEY SAY A PICTURE is worth a thousand words. But what about a chart?

A few weeks back, I noted that the stock market had become unusually top-heavy, with just five companies—Alphabet (i.e. Google), Amazon, Apple, Facebook and Microsoft—accounting for 20% of the overall value of the S&P 500. A chart that appeared online last week illustrates the impact of that imbalance. What it showed, in a nutshell, is that the overall S&P 500 is around breakeven for the year, but only because of those five stocks.

In 2020, the five have collectively gained some 35%. What about the other 495 stocks in the index? As a group, they’ve 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 pretty much breakeven. 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 34% in the early days of COVID-19, 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 stocks are in rough shape and reflect the reality of the ongoing pandemic. As of Friday morning, more than 300 of the 500 stocks in the S&P 500 were down this year—some very significantly. Banks are down 20% and energy stocks 35%. Travel-related stocks are faring even worse: Marriott is down 42%, American Airlines 60% and Norwegian Cruise Lines 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 as the chart makes clear, they’re just part of the story. Many other stocks provide a more level-headed reflection of the state of the economy.

Confirming the counterintuitive. A while back, I mentioned the results of a study by finance professor Hendrik Bessembinder. Over the prior 90 years, most stocks had been duds, delivering negative returns. Less than 4% of all stocks—a tiny fraction—had accounted for all of the stock market’s gains over and above Treasury bills, a striking example of what’s called skewness. 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, aren’t 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. 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. Since we can’t know the future, the best defense—in my view—is diversification, and the easiest and most cost-effective way to achieve that 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 and General Mills—would provide investors with a safe haven. That’s because consumers tend to keep buying basics like paper towels, 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 behind the overall market. Meanwhile, the traditionally riskier stocks of high-growth technology companies now appear 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. Even when it seems to follow a pattern, that pattern is subject to change without notice. Result: 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.

Adam M. Grossman’s previous articles include What to Worry AboutFed Up and Two Reasons to Worry.  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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