Fall 2019 The S&P 500 Index is not the North Star
“Nothing is more dangerous than an obvious fact”
- Sherlock Holmes
On March 6, 2009 the S&P 500 hit a low of about 666.1 On July 26, 2019 the S&P 500 hit an all-time high of 3027.2 That’s an increase of 354% and an annualized return of 15.8%. This is despite pundits calling for the end of the bull market for at least the last several years. This return compares to the long-term average annual return from January 1, 1926 to August 1, 2019 of 10%. Hmmm. Is the recent outperformance ushering in a new paradigm? Should investors continue buying S&P 500 index ETF’s? Is the S&P 500 the North Star of investing, guiding investors to future riches? Or are the recent extraordinary returns a cause for concern? In this newsletter I will address these questions and more.
“Beware of false knowledge; it is more dangerous than ignorance”
- George Bernard Shaw
As the well-known warning admonishes, “Past performance is no guarantee of future results”. The S&P 500 is nothing more than a scorecard of past successes. If you are an index fund investor and believe what happened to the index in the past will happen again in the future, then you may want to consider getting out of the S&P 500 index. I say this due to the potential for a “regression to the mean”, a statistical term whereby outperformance reverts to its long-term average or “mean”. For example, a baseball player with a .250 lifetime batting average who starts batting .500 may be on the verge of greatness. But if it is just a “hot streak”, then he has to bat below .500, indeed below .250, to return to his average. With the S&P 500’s last decade “hot streak” of 15.8%, investors should consider whether this outperformance can continue. If not, the index is due for a period of underperformance as it regresses to its mean. That could happen quickly and violently or via negligible returns for years.
“A great many people think they are thinking when they are merely rearranging their prejudices”
- William James, “Father of American Psychology”
The further the March 6, 2009 low recedes in the rearview mirror, the less scary the past looks and the more confident, indeed over-confident, investors become about what lies ahead. Some succumb to FOMO (fear of missing out) or with low interest rates, NOA (no other alternative) to stocks for high returns. A sign of FOMO or NOA is the “crowded trade”, a phenomenon whereby investors “crowd” into popular stocks like the FAANGS (Facebook, Apple, Amazon, Netflix and Google). You say you are not worried because your S&P 500 index fund owns 495 other stocks? You may not be as diversified as you think. Worse, maybe the S&P 500 index is not the North Star of stock market investing, a path or beacon guiding investors to future wealth creation. The North Star guides sailors today as it guided Columbus centuries ago because it is stationary and unchanging. The S&P 500 is not stationary and unchanging. Over 50% of the companies currently in today’s S&P 500 were not in the index 20 year ago. On average, 22 companies are cycled out of the index each year.3
The top 10 stocks by value in the S&P 500 today have been significant drivers of index’s performance over the past decade. Yet just as the New England Patriots are unlikely to remain the “benchmark” of professional football forever, these top stocks probably won’t lead the index’s future returns, even if they don’t get booted from the index. They are no longer as small, nimble, fast-growing (or cheap) as they were back in 2008-2009. As we remind investors, even Amazon is not the next Amazon.
If the cornerstone of your stock portfolio consists primarily of buying an S&P 500 index ETF, these 10 stocks now comprise nearly 22% of the index.4 The other 495 (yes, right now there are 505 stocks in the S&P 500) comprise the remaining 78%. That means many of the S&P 500 stocks, including future leaders, are currently incapable of moving the needle, for better or worse. So why own 505 stocks? Might this bull market be “lifting all boats”, even the ones we will eventually find out aren’t seaworthy?
The top 10 stocks in the S&P 500 and their annual total returns from March 6, 2009 to the index’s July 26, 2019 high are: Microsoft (+27%), Apple (+37%), Amazon (+39%), Facebook (+24% since S&P 500 addition in December 2013), Berkshire Hathaway (+16%), JP Morgan (+24%), Alphabet (+22% for C-Class), Johnson & Johnson (+14%) and Exxon (+5%). Do you see the danger? All but Exxon outperformed the index’s historic average return. All but Exxon and J&J even outperformed the S&P 500’s last decade hot streak! It is right to question whether in the future these same stocks will duplicate their past performance and outperform the rest of the S&P 500. Past performance is no guarantee of future results, except that is what index fund investors are often banking on!
“In the short term a lot, in the medium term a little, in the long term, nothing at all”
- Jeremy Grantham, noted investor commenting about what we learned during the Financial Crisis of 2008-2009
If the S&P 500 is unlikely to duplicate its past performance, how should one invest for the future? Start by recognizing the S&P 500 index is not the stationary and unchanging North Star of investing. It can hardly be called “passive” investing if over 50% of the stocks in the S&P 500 index are different since 1999! Further, if nearly 22% of the index is concentrated in just 10 stocks, index funds may not be as “safe” as you think. If these top performers regress to their mean, this will likely drag down the entire index (along with index fund investors) before future leaders, buried far down in the list, can emerge to dominate. If you don’t believe me, in 1999 the S&P 500 returned +21.04%, capping a multi-year string of great performance and exuberance over index investing. But in 2000-2002 the S&P 500 returned -9.1%, -11.89% and -22.1% respectively. That regression panicked many investors who got out of the market…just in time to miss the +28.7%, +10.9% and +4.9% total returns of 2003, 2004 and 2005.5
Yet all is not hopeless for investors. In sports, fans often claim “there will never be another like…” then another comes along. In golf, there was the incomparable Sam Snead followed by the incomparable Arnold Palmer, then the incomparable Jack Nicklaus, then the incomparable Tiger Woods. All were indeed incomparable and all took the game to new heights. Likewise with stocks. Wealth continues to be created every day, yet often by different companies than in the past. If you are interested in the future performance of your portfolio, here are 3 steps to consider.
“Everyone wants the cure for cancer that tastes like chocolate”
- Panos A.
- Invest in the future leaders. Yes, I know they are not easy to identify and investors demand easy! Hence the attraction of “robo-advisors”, which unfortunately cannot be programmed with a crystal ball. Future leaders look like “seeds”, not what they will look like in their “mature” state. Amazon IPO’d in 1997 and hit a post-IPO low of $1.40/share on May 22, 1997.6 It was added to the S&P 500 index in 2005, after it appreciated 3,327% from that low.7 It is up another 3,998% since then, though today still only constitutes 3% of the index, hardly enough to retire on.8 Furthermore, “seeds” are cheaper investments than paying for mature “trees” which are still susceptible to being blown over in a strong economic downturn. Just ask #114, General Motors. Big companies can get complacent. In 1999 GE was the #2 stock in the S&P 500 around $56/share. Today it is #75 selling for around $9/share.9
- Concentrate (carefully) if you want to create That may sound scary, but realize that if you owned an S&P 500 index fund or ETF over the past decade and were happy, your return came, in large part, from concentration in those top 10 stocks whether you knew it or not. Statistically, a portfolio of at least 30 stocks captures 86% of the diversification of the market and reduces the diluting effect of owning 470 others.10 Though some future leaders may already be in the S&P 500 index, it is likely they are currently buried too far down in the index to dominate and contribute to performance. Other future leaders may not get added to the index until they have already performed significantly. We consider the 35 stocks in our portfolios as having “seats at the table”. We endeavor to invite only very deserving stocks and cannot add a new stock until we kick out the least deserving one from its seat. This keeps us from “collecting” stocks and diluting returns. Of course it also keeps us on our toes, constantly reviewing who has a seat and whether there is a more deserving stock.
- Use volatility to your advantage and then remain patient. This sounds simple yet is the most important and most difficult step of all. Investors are bombarded 24X7 with stories of doom, gloom and the recession that is always “right around the corner”. This creates market volatility which also creates the opportunity to pay a more favorable price for potential future market-leading
In the end, the S&P 500 Index has come to be viewed by many investors as the North Star of stock market investing, a stationary and unchanging “guide” or path to future wealth creation and a “benchmark” for comparison to your returns. It is neither. It is a scorecard of what worked in the past. The path to continued (or new) personal wealth creation in the stock market is most likely investing in future leading stocks not past ones. And… the only real “benchmark” of your progress is your own results.
AUDI PARTEM ALTERAM
Hear the Other Side.
1https://finance.yahoo.com/quote/%5EGSPC/history?period1=123631 5600&period2=1236402000&interval=1d&filter=history&frequency=1d
2https://finance.yahoo.com/quote/%5EGSPC/history?period1=1564113
600&period2=1564200000&interval=1d&filter=history&frequency=1d
3https://www.businessinsider.com/sp-500-index-constituent-turnover-
4https://www.slickcharts.com/sp500 (21.61% as of 09/06/201)
5https://www.slickcharts.com/sp500/returns
6https://finance.yahoo.com/quote/AMZN/history?period1=864100800&
period2=864878400&interval=1d&filter=history&frequency=1d
7wsj.com/articles/SB113207902652797811
8https://www.slickcharts.com/sp500 (data as of 09/06/19) 9https://www.slickcharts.com/sp500 (data as of 09/06/19)
10http://ppca-inc.com/Articles/DiversByNumbers.pdf
Thoughts for Investors is a quarterly newsletter written for clients since 1997 by this author. The purpose is two-fold. First, it is meant to help explain the investment philosophy that guides the author’s approach to portfolio management. Second, it is meant to remind readers of important behavioral skills that the author believes are necessary to help them become successful investors. The author welcomes comments and criticisms, especially if they can be shared for the betterment of all investors. Quotation is permitted with full attribution.
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