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Too much of a good thing?

Wasif Latif 18-Nov-2020

Ice Cream

 

As we progress through the fourth quarter, investors everywhere are still grappling with a global pandemic despite the reported progress on a vaccine. The reality is that COVID-19 cases are rising again in some areas, and local economies are in various stages of reopening (or reclosing). Thus, it’s difficult to make bold predictions on economic growth or otherwise handicap the stock market for the remainder of 2020 and beyond.

 

However, based on recent spending patterns and the uncertainty regarding the political will for more robust fiscal stimulus, the ongoing recovery is likely to be choppy at best, rather than the V-shaped recovery initially suggested by the market rebound. But one thing is certain. It is very likely that the post-pandemic world will usher in new market leadership. This has ramifications for equity portfolios.

 

In recent years, market leadership has been utterly dominated by just a handful of domestic mega-cap stocks. Although these large and successful companies have been powering returns in the S&P 500® Index—easily the most recognizable proxy for “the market”—it may have left investors with too much of a good thing.

 

Market cap-weighted benchmarks like the S&P 500® Index—whereby the constituent makeup is based on company size—may not be the optimal way to invest for the long-term. Consider a few startling market statistics:

 

  •  As of September 30, 2020, just six high-profile tech stocks—Facebook, Apple, Amazon, Netflix, Google (i.e. Alphabet) and Microsoft, often referred to as FAANG + M—represented approximately 23.4% of entire S&P 500 Index.
  • The weight of the single largest constituent in the S&P 500 Index, Apple as of the end of the third quarter, is approximately the same size as the combined weight of the 196 smallest positions in the index.
  • This is the most concentrated the S&P 500 Index has been in just a few stocks since 1975 (45 years ago), when names like Xerox and Kodak dominated. Investors should understand that market leadership is dynamic and changes, even when it’s difficult to fathom.

 

Yes, narrow leadership and concentration has provided a tailwind for investors relying on a cap-weighted index for their core equities allocation. And although the backdrop of the pandemic has allowed some of these mega-caps to emerge even larger and stronger, they may not remain in the top spots forever. What happens if and when this spectacular run of mega-cap dominance ends?

 

This pandemic and the macroeconomic backdrop weave a complicated story, and nobody knows what the economic recovery trajectory will be going forward. But in this uncertain environment where outlooks and predictions are dubious at best, perhaps the single most important action is for investors to maintain—or rather recommit—to diversification. That might translate into allocating to an alternative index methodology, such as weighting by volatility or risk. I believe that at some point soon there will be a reversion to the mean, and we will be in an environment where meaningful diversification will be rewarded once again.

 

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