S&P less diversified than you might think

Right now, the American economy is like an F-22 Raptor fighter jet — only without 100% of its weapons in operation. It’s still the best in the world and would win any battle, but it’s not fully charged. We have a little way to go before our economic aircraft is fully operational.

Tech makes up a big chunk of the ready-to-go artillery on our jet. After all, what sector is better equipped to flourish in a stay-at-home or socially distanced economy? Looking from Jan. 1 to the third week in July, the tech sector has dominated stocks, up more than 15%. Health care is next, with a paltry 3% increase. The vast majority of other industry sectors are negative on the year, including financials, industrials, utilities, energy and telecom. Also, as of last week, the market-cap-weighted performance of the top five stocks in the S&P 500 has been up an astounding 32% year-to-date. The performance of the other 495 has been down 7.7%, all according to data from Strategas.

Remember that capweighted means that the largest companies have the most impact. Using this method, as a whole, the overall average is only down a fraction of a percent year-to-date. Compare this approach to the equalweighted method, where every company, small and large, has the same impact. Looking at the data this way, the S&P 500 is down roughly 8% this year as of mid-July!

One of the tenets of the S&P 500 is the diversification it offers. So, cap-weighted, we now have five stocks that make up almost 25% of the S&P 500 and nearly 45% of the Nasdaq. That’s only 1% of the total stocks in the S&P 500, folks. This is an outsized concentration and one attributed to

the current tech surge. With five stocks making up one-quarter of this $28 trillion index, it’s hard to call the S&P 500 diversified.

The last time we saw this much concentration was during the tech bubble of the early 2000s. I don’t believe our current situation is exactly like the tech boom of 1999 and the bust that followed, as today’s leaders are actually very strong companies with dominant market position. However, investors have piled into this sector, so they come with high price tags relative to their sales and earning much like in 1999.

What we did see once tech began to crater in the early part of the 2000s was there were plenty of other sectors that did very well. I believe we could see the same thing over the next year.

If you invest in dividend-paying stocks — a key holding for income investing — you may feel such stocks have lost their luster. But I don’t think this trend will last forever. Over the last three years, dividend-paying stocks that regularly increase their dividends averaged a 5.4% rate of return per year, while their non-dividend-paying counterparts (growth-only stocks) were up 11.5%. Many folks may be questioning whether dividend-payers will ever come back.

The last time a discrepancy like this happened was between 1995-1999. Growth-only stocks averaged an annualized 29% increase versus 17% for dividend-growers. Then, from 1999 to 2001, dividend growers averaged +10% versus -8% for growth stocks. Yep, they were up 10% during the tech crash, while purely “growth” companies lost money.

Iwanttosharethe Oracle of Omaha’s “lag story.” From mid-1998 to the end of 1999, Warren Buffett wasn’t in tech at all. He stuck to his knitting, preferring his pretech investment strategy. During that same time, he was down 28%, while the S&P 500 rocketed up 32%. So, call it an almost negative 30% compared to positive 30%.

People opined that the Sage had lost his touch. Over the next 10 years, however, the S&P 500’s total return was negative 9%, and Buffett was up 76%.

The moral of this story isn’t that the tech sector is bad. Not at all. However, at some point, we could see today’s underperformers become tomorrow’s winners, due to an age-old investment maxim called reversion to the mean.

Right now, tech has the rest of the market in handcuffs. And that makes sense. The COVID19 economy is ripe for that sector. But we’ll likely return to spending our evenings and weekends away from screens; it’s just a question of when.

So, think of it in terms of the entire market. It’s filled with hundreds of other companies that run fantastic businesses. These merely seem out of favor for the time being. The handcuffs will come off eventually, maybe as soon as the spring if vaccine hopes come to fruition.

Beware the desire to chase today’s narrow list of high-flying stocks. This feeling usually only happens in times of extremes. Keep it consistent.

When one style — like growth or tech — trounces everything else for a long time, investors tend to flood these stocks, thinking the ride will never, ever end. Instead, the stock heavyweights of the day eventually get trounced by their counterparts in a reversion to the mean. I think dividend-paying stocks are the Rocky Balboa in this story. We don’t know the time nor the hour, but at some point, I think we’ll likely see the underdog turn into the comeback kid.