The Standard and Poor's 500 index (S&P 500) was created on March 4, 1957. The S&P 500 was designed to track the performance of the largest stocks that trade in the United States and is now widely recognized as the benchmark for U.S. stocks in general. The index weights each stock according to the overall size of each company (referred to as market capitalization) adjusted for the number of shares available for public trading.
For instance, Amazon, the fourth largest company in the world, has a weighting of 3.72% in the index, while Wal-Mart, the twenty-fourth largest company has a weighting of 0.63% as of June 26, 2024. The larger the company, the larger the weighting in the index.
For comparison, not all indices follow the same method of weighting stocks. The Dow Jones is a price-weighted index, meaning that United Health Group (stock price of $486) has double the weighting of Apple (stock price of $213 at the time of this writing) despite being about $2.5 trillion smaller in terms of overall company size.
Other indices are “equal-weighted” meaning that each stock carries the same weighting in the index regardless of stock price or company value.
Why does any of this matter? Many passive investment strategies follow the S&P 500 as their benchmark and hold similar stocks in similar weightings. The decision to weight the index by company size means that as companies increase in value, they make up a larger portion of the index, and thus a larger portion of most investment portfolios. The methodology of the S&P 500 weighting rewards the performance of large companies and minimizes the impact of smaller companies in the index.
At the moment, Microsoft, Nvidia, and Apple are the three most valuable companies in the country, and thus hold the largest weightings. The combined weight of those three stocks now accounts for more than 21% of the entire index. The other 497 stocks make up the difference.
This concentration of the three largest stocks is now the largest since the early 1930s according to Goldman Sachs research. The result is that the S&P 500 performance is primarily impacted by a handful of stocks (the top 10 stocks make up about 37% of the total index). As long as those larger companies are performing well, then the index is likely to show strong performance even if the rest of the companies in the index aren’t doing as well.
Interestingly, the outperformance of these huge companies has been the story of the market for the last few years. If we compare the performance of the S&P 500 in the current weighting with the performance of an “equal weight” version of the same index, we see that the “equal weight” index has underperformed by 9.9% so far this year and 12.4% last year (note the bottom right of the chart below highlighted in blue). The last time we saw similar underperformance was in 1998-1999.
In other words, the majority of stocks in the index aren’t keeping pace with the larger concentrated names at the top of the index. That’s not necessarily bad, but it could signal warning signs for those largest stocks and an opportunity in the underperforming parts of the market.
1999 marked the latter days of the dot-com bubble when large, tech-related companies were all the rage. The S&P 500 was on a tear, concluding its fifth consecutive year of 20%+ returns. Meanwhile, smaller companies were largely ignored.
The Russell 2000 index is a common benchmark for smaller companies as the index excludes the top 1000 largest stocks in the country. The chart below compares the ratio of the two indices. In late 1999 the tide turned and investors began to sell the largest stocks and move money into smaller companies. Over the next seven years, smaller companies outperformed larger stocks, returning nearly 90% versus only a 10% return for the S&P 500.
Another interesting similarity to the late 1990s is the current investor focus on stocks in the technology space. Investors were convinced (correctly, I might add) that the Internet would change the way we all did business and shopped. Stocks like Sun Microsystems, Yahoo!, AOL, and Cisco were the hot stocks to own. Despite a lack of earnings (and revenue in some cases), investors bid up the share price of those tech names to the point at which investors were paying nearly $7 for every $1 in revenue for stocks in the technology sector. In time, expectations fell flat (or didn’t come quickly enough) and share prices began to fall. By 2009, valuations were dramatically lower and investors could purchase shares of technology companies for less than $2 per $1 of revenue. Today the price-to-revenue ratio of tech stocks is near $9 per $1 of revenue; higher than the dot-com bubble peak.
Generally speaking, investors buy Technology stocks because they expect the company to grow. The expectations are high. Stocks with high revenue growth and low dividend rates (among other characteristics) are typically categorized as “growth” stocks as opposed to “value” stocks.
Johnson and Johnson, on the other hand, is a large, well-established, well-diversified healthcare conglomerate. They pay out a large part of their earnings (about 70%) each year as a dividend. The 10-year average revenue growth rate is less than 3%. Investors purchase shares of Johnson and Johnson for stability, cash flow, and predictability rather than explosive revenue growth.
Much like the dot-com bubble, growth stocks have garnered more attention (and more investment dollars) from investors in recent years. As a result, “growth” stocks are currently trading at their highest ratio to “value” stocks since the dot-com bubble burst in the summer of 2000. Much like we saw with smaller companies, in the summer of 2000 money began flowing into “value” stocks.
Again, when lofty expectations weren’t met, investors turned to predictability and cash flow. As a result, “value” stocks trounced “growth” returning 84% over the next seven years while “growth” stocks declined by 27% (as measured by the Russell 1000 Growth v Russell 1000 Value).
Where does this leave us today? The pendulum has likely swung too far in favor of large growth-oriented companies. The expectations are too high and investors are too optimistic. Warren Buffett’s famous saying feels applicable at the moment; “Be fearful when others are greedy, and be greedy when others are fearful.” There aren’t many fearful investors at the moment.
In 1963, a survey was created by AW Cohen to measure investor enthusiasm around stocks. The survey, known as the Investors Intelligence Sentiment Index is one of the longest-standing measures of investor expectations. Over the last fifty years, the survey results have consistently shown that investors were almost always wrong at market turning points. They were far too optimistic during good times and far too pessimistic during bad things. The sentiment indicator is now used primarily as a contrarian indicator. When investors are overly optimistic, it’s time to get safer and vice versa.
As of June 19th, investor optimism is in the 95th percentile. Historically, when more than 60.8% of survey respondents are bullish, the market does the worst over every time frame (three months to five years and everything in between). The most lucrative time to invest in the stock market is when investor optimism is at its lowest point, as indicated in the chart above.
What’s the takeaway? Be ready for a change in the tide. Smaller companies and value-oriented stocks have been out of favor for quite a while. It may take time for investor appetite to shift or it may happen overnight. Either way, we have enough history to suggest that investor expectations can outstrip reality.
Vanguard put forth a 10-year outlook at the end of March. They expect US growth stocks to be the worst-performing asset class over the next decade with an annualized return projection of only 0.4% - 2.4%. Value stocks, on the other hand, are projected to return 4.1% - 6.1%. Small-cap stocks are projected to return 4.3% - 6.3%. Take those numbers with a grain of salt, and don’t get hung up on the specifics, but the point is clear, investor appetite has a history of swinging from one direction to another. The stocks, sectors and style of investing in favor at the moment likely won’t stay the same over the next several years.
*Note – our thoughts and content are original, but we use various charts from Charlie Bilello. Charlie is a Charted Market Technician and works as the director of research at Pension Partners, LLC. He is a good person to follow on X (formerly Twitter) and can be found at @charliebilello
Any opinions are those of Brady Raanes and not necessarily those of Raymond James. This material is being provided for information purposes only and is not a complete description, nor is it a recommendation. The information has been obtained from sources considered to be reliable, but we do not guarantee that the foregoing material is accurate or complete.
Any information is not a complete summary or statement of all available data necessary for making an investment decision and does not constitute a recommendation. Expressions of opinion are as of this date and are subject to change without notice. This information is not intended as a solicitation or an offer to buy or sell any security referred to herein.
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Past performance may not be indicative of future results. Investing involves risk and you may incur a profit or loss regardless of strategy selected. Prior to making an investment decision, please consult with your financial advisor about your individual situation.
The S&P 500 is an unmanaged index of 500 widely held stocks that is generally considered representative of the U.S. stock market. Keep in mind that individuals cannot invest directly in any index, and index performance does not include transaction costs or other fees, which will affect actual investment performance.
The Russell 3000 Index measures the performance of the 3,000 largest U.S. companies based on total market capitalization, which represents approximately 98% of the investable U.S. equity market. The Russell 2000 Index measures the performance of the 2,000 smallest companies in the Russell 3000 Index, which represent approximately 8% of the total market capitalization of the Russell 3000 Index.