Many people much smarter than I have been going great lengths to explain why there’s a disconnect between the stock market and the economy. Something, something, don’t fight the fed is usually the answer. So save your time and skip that article next time you feel yourself falling for the clickbait. I’m not here to answer that question, but I am here to help you understand how the market is structured. Structure matters.
If you live in an expensive house built on a poor foundation, it won’t be worth the price you paid for it. The same is true of the market. For the purpose of this article, I’m defining, “the market” as the S&P 500. Why? Because it is the most liquid index in the world and the most widely used benchmark by investment institutions. And as I’m going to show you, the market is reliant on the performance of a very few gigantic companies. Whether that’s the way it should be isn’t nearly as important as understanding that that’s the way it is.
What moves the S&P500?
The S&P 500 is a cap-weighted index. This means that the stocks that comprise the index are weighted by market capitalization. I.E. bigger stocks have a bigger weight in the S&P500. Therefore, a stock like Apple (AAPL), with a market capitalization of $1.6 trillion, has a far larger impact on the S&P500 than a stock like JP Morgan (JPM), which is the largest US bank by total assets. Both stocks are included in the S&P500 index, but AAPL represents 5.75% of the index whereas JPM is only 1.09% of the index. If AAPL rises 5% and no other index components move, the S&P500 will rise by 0.29% (almost 1/3 of 1%), all thanks to AAPL. For JPM to have a similar impact on the index, it would need to rise by more than 26%.
This helps illustrate a key point when it comes to the market: only a handful of stocks matter. In fact, the top 10 weighted stocks in the S&P500 comprise 27% of the index. Each subsequent stock in the index is less important than the one before it, for no other reason than it has less weighting in the index itself. Consider the following graph:
The top 50 stocks in the S&P500, which represent just 10% of the stocks in the index, account for more than half of the index’s total weighting. What’s more, the top three stocks have a greater impact on the index than the bottom 305 stocks! (Yes, there are actually 505 total stocks in the S&P500). Put another way, the top 0.60% (3/505 = 0.60%) of the stocks in the index are more important than the bottom 60% (305/505 = 60%). All of this begs the question: which stocks actually matter?
An AAPL a day keeps the pullback away
The top 10 stocks in the S&P 500 represent 27% of the index and are dominated by tech behemoths and other household names. These are the most important stocks in the market:
So when the conversation turns to if the market will go higher or lower, you can surmise a lot simply by looking at the top 10 stocks. You can narrow your focus even more and just look at the top three holdings of Microsoft (MSFT), Apple (AAPL), and Amazon (AMZN), all of which have done very well this year and account for more than 15% of the index:
Don’t forget, these top three stocks, because of their size, are more important to the performance of the market than any other trio of stocks in the entire index. It likely surprises some to learn that MSFT, AAPL, and AMZN together carry a greater weighting in the S&P500 than the bottom 305 stocks combined! But it’s true.
Some sectors just don’t matter
As the media highlights the challenges facing industries like travel & leisure, banking, and energy, understand that the performance of these sectors has little impact on the performance of the market. The reason is they simply do not carry enough weight in the market to impact returns. Here is a breakdown of market weightings by sector:
That compares to just a 2% loss for the S&P500. How can these giant bank stocks have such little impact on the market? Because they don’t have the market capitalization weighting in the index that the aforementioned tech titans do. If financial stocks made up the weight in the market that technology stocks did, then the market would be much lower than it is right now.
The same goes for airline stocks, which have become a lightning rod for investment discussion but essentially have zero impact on the market’s performance. United Airlines (UAL), Southwest (LUV), Delta (DAL), American Airlines (AAL), and Alaskan Air (ALK) enjoy a combined weighting in the market of just 0.20% (1/5th of 1%). By the way, I’ve been amazed at how many people have asked me recently if I think airline stocks are a good buy. I’ve been in this business for 12 years and never once had anyone ask me my opinion on airline stocks. It’s amazing how attracted people are to something that just went down 75%. But I digress.
What about the bubble factor?
Recently, much has also been made of certain pockets of the market trading similar to the dot com bubble in 1999. Market observers point to stocks like Shopify (SHOP) and Tesla (TSLA) as a sign that investors are throwing value by the wayside and just chasing momentum. If you subscribe to traditional valuation metrics such as p/e ratios and price/sales ratios then the following list probably looks like a bunch of overvalued garbage to you:
None of these stocks have any “P/E” ratio because in order to have one you need to have net income. And not a single one of these stocks is profitable. Yet they’ve all gone up huge this year and are oft-cited as evidence of a bubble brewing in the market.
Now guess how many of these stocks are in the S&P500… zero. Are these stocks in a bubble? Maybe, but it’s not a bubble that’s building inside of the S&P500, and that’s an important distinguishing factor.
Why it feels like a disconnect and what matters now
There’s no doubt that the economy entered a rough patch in March when the coronavirus pandemic took hold. But in the market’s eyes, it appears that crisis has already abated. This is likely what is driving the conversation about the supposed disconnect between the market and the economy. People see the economy through the vast array of businesses that are struggling through the pandemic instead of through the giants that matter most to the stock market. And believe it or not, MSFT, AAPL, and AMZN are thriving in the current economic environment.
The intention of this article isn’t to diminish the economic struggle people are going through. Rather, my goal is to provide clear insight into what actually drives market performance. In that case, it’s really as simple as answering this question: do you believe the share price of the following companies will be higher in the future than they are today?
Because at the end of the day, whether it should be this way or not, these are the 10 stocks that matter most to the market. So unless you think two of the top three or six of the top 10 stocks are in trouble, then you should expect the market to stay steady. I don’t make the rules, but it’s important to know the rule book.
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