By David Nelson, CFA
Since the dawn of index funds investors have grappled with the decision to place their hard earned money with portfolio managers or just buy the index. As money management styles fall in and out of favor, investors rushed from one fund to the next chasing the Holy Grail. Since most indexes are market cap weighted, it stands to reason that the health and well-being of the largest companies in the index, to a large degree will determine performance.
We’ve all witnessed the days when not owning the largest company was detrimental to your financial health. It wasn’t that long ago Apple (AAPL) was a Wall Street darling and a must own stock. Today, its institutional ownership has declined dramatically. A couple of years ago portfolio managers who didn’t have a descent weighting were doomed to trail their peers. I’ve been in this business long enough to remember when General Electric (GE) enjoyed the same status. Frankly, neither is all that important in a portfolio today.
The Fed
Since the financial crisis, dramatic and unconventional action from the Federal Reserve added another dynamic. Quantitative easing along with a zero interest rate policy, created a risk on risk off mentality where stocks moved in the same direction. 90% up and down days once a rarity on Wall Street became the norm. When all stocks are moving in unison there is very little money managers can do to outperform.
The best thing portfolio managers did in the last 5 years was keeping investors in the game. Every little wrinkle or geopolitical event floods the phone banks with investors screaming it’s 2008 all over again.
Good News for Stock Pickers
On Sunday, the fifth anniversary of the financial crisis, the Wall Street Journal pointed out that stock correlations to each other are falling. The chart below, reprinted in the Journal comes from Jason Trennert’s team at Strategas Partners and shows that the number of days more than 90% of stocks in the S&P 500 move in the same direction has been declining since 2011. Today that number sits at the lowest levels seen since 2009. Trust me, this is music to money managers everywhere. What a concept! Good stocks go up and bad stocks go down.
Let’s take this a little further and analyze what’s been happening over the last year from a market cap basis. So how are these mega caps doing? There are always exceptions but slowly their relative performance has been on the decline.
SPY vs. OEF
Let’s look at a comparison of the two very popular ETF’s, (SPY) – S&P 500 and (OEF) – S&P 100. Obviously as the name implies the (SPY) represents the entire S&P 500 market cap weighted Index and (OEF) the 100 largest. The chart shows the performance of (OEF) relative to (SPY). As you can see the relative performance has been weakening and that trend continues into 2014
Let’s Drill Down Further
If you we look at the 20 largest companies in the S&P 500 which represent almost 29% of the index, we see more than half have underperformed so far this year. These top 20 represent 4% of the index but almost 29% of the weight. However, the mega caps have only delivered 16% of the performance. We could certainly see a reversal of this new dynamic but one data point that is likely to stay with us is that 90% up and down days are going to be the exception.
S&P Top 20
Equal Weight
It’s important to point out that the equal weighted index (RSP) is beating both. Smaller more nimble companies tend to outperform in a bull market cycle. Given the market is up over 150%, celebrating its 5th anniversary of the low in 2009, I think it is safe to say we are in a bull market.
Not Impressed
Admittedly this isn’t conclusive data and maybe a stretch. Perhaps I should call it green shoots. However, I look at the top 20 stocks in the S&P and with the exception of a few I’m not impressed.
Apple (AAPL) is now so large, I’m not sure any product can really move the needle. Exxon (XOM) and Chevron (CVX) continue to struggle in an oil patch that seems better suited to the quick and nimble. Walmart (WMT) sales are ho – hum. Proctor & Gamble (PG) & Coke (KO) certainly aren’t getting a boost from the emerging markets they thought they would. My least favorite name (IBM) has a broken business model. Flat sales and the inability to cut costs further will make it difficult for them to grow earnings.
It seems like all the action in the top 20 is going to come from the new economy names like Google (GOOG) and Facebook (FB). That’s a lot to ask from two stocks that already have had meteoric runs.
Emerging markets
Nowhere is active investing more suited to out-perform than the emerging markets. With China & Brazil representing close to 30% of the iShares MSCI Emerging Markets ETF (EEM), you don’t have to be Warren Buffet to figure out you might do better digging beneath the surface for your emerging market picks
Time for Some Payback
I know Jack Bogle the father of index funds would tell you it’s impossible to outperform the index and I’ll be the first to concede the average fund manager doesn’t beat the S&P but is that going to be what we strive for; average. It’s almost Un-American. If I’m putting a golf team together I don’t want the average duffer. I want Tiger or Phil on my team. Even if Jack proves to be correct in the long term, given recent trends I believe stock pickers are in a position to get some payback.
I freely admit this article along with my prediction is completely self-serving. The topic is a constant source of discussion among managers here at Belpointe. As in most contests the score at the end of the game will be the final arbiter. Let’s meet here on New Year’s Eve and see who crosses the finish line first.
Funds managed by David Nelson are long AAPL & GOOG.
