What This Earning Season Tells Us About The Current Stock Market – Forbes

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Ah, quarterly earnings season, when an investor’s thoughts turn to questions like, “how many stocks in my portfolio will see their price change by at least 5% today, and how many of those will be up or down?”  The most commonly-quoted “market” volatility indicator, the VIX, is near record lows, as it has been for most of the last few years.  But as usual, if you look beyond the quick headlines, you see a very different picture.  Individual stocks and sectors are extremely volatile these days, and the recently-completed round of quarterly earnings reports from S&P 500 companies is simply the latest evidence that the headline indexes are masking a very different market underneath.  This is why I am convinced that we are not in a stock market bubble, but rather a bubble in mega-cap index investing.

YCharts 2017

Above you see a chart of a very brief period, the month ending November 7 of this year.  But that brief time is just a continuation of a 2017 that has seen an increasing separation between the biggest companies (many in tech and financial sectors) and the rest.  The Nasdaq 100 was up over 4%, which helped pull up the S&P 500 by 1.76%.  But the average stock (S&P 500 Equal-Weighted) was up a mere 0.66% during what probably appeared to many to be a period of strong returns.  Lastly, look at the SDOG ETF, an equal-weighted index of the 5 highest yielding stocks in each of the S&P 500’s 10 sectors.  It was down 0.65%.  This continues a trudging year for higher-yield stocks which I have discussed several times with you this year.  This type of separation between the “market” that people follow in TV headlines and cocktail party chatter, and the group of stocks whose dividend income can play a pivotal role in the lifestyle objectives of retirees is something to watch carefully.  Trends like this have a way of reversing, and when they do, it can be quite a scene.

The more the “market” behaves more like a set of “haves” and “have-nots,” the more vulnerable the top-heavy S&P 500 and Nasdaq are set up for a sizable, emotional decline that threatens to erase a significant chunk of this year’s gains.  When will that happen?  Heck if I know, which is why I urge investors not to simply try to guess their way through this late-stage bull market activity.  In fact, the failure of so many stocks to not only fail to rise with the “market” but see their values decline this year offers an opportunity to put one’s nose to the ground and determine where they could be long-term value.  I suspect such value will be found not in 2017’s biggest winners, but in many companies currently out of favor.  That’s a bigger conversation than this article can cover, so here is a snapshot I created by dividing the S&P 500’s total market capitalization (currently 505 stocks, to be exact) into 3 equal segments.  Here it is:

YCharts 2017

I can make several key observations from this snapshot, which can help you understand just how severely tilted the market currently is in favor of the mega-cap stocks.

  1. The top 1/3 of the 505-stock index by market cap is only made up of 20 stocks! In a bygone era, investors knew of a group called the “Nifty 50.”  Perhaps this is a Nifty 20, but for the sake of investors in S&P 500 and similar index funds, I hope it doesn’t end up like the Nifty 50 did.  If you want to learn more on that, look up the 1973-1974 U.S. stock bear market.
  2. About 80% of the S&P’s stocks are part of the bottom 1/3 by market cap. The top 100 stocks in size make up 2/3 of the total index’s weight.
  3. Those top 20 stocks have had a very Teflon-like run this year, and the period covered in this table was no exception. Only one of the 20 stocks was down at least 5% during this 1 month period, but…
  4. …more than 20% of the rest of the S&P was DOWN at least 5% over the course of that same period. That is a testament to how volatile individual stocks are in an environment where earnings and other company announcements are celebrated or punished with a voracity we have not seen for some time.
  5. That group of 20 largest stocks averaged a 5.4% gain during this 1-month period. Earnings were good, or at least better than analysts expected.  What we must determine going forward is which companies now have expectations that are risky because they are so high, and which may represent “contrarian” situations where low expectations by investors can be the key to strong returns in the coming years.  And again, look at the return of the average stock in the middle 1/3 and bottom 1/3 by market cap.  Can you say “top-heavy market?”

This is just the latest piece of evidence that this year’s stock market is not a market at all.  It’s a private club for a select group of popular stocks.  That club can rule the neighborhood for a while, but the herd mentality that follows its ascent must be recognized and dealt with by investors, before the eventual sea change occurs.

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Comments provided are informational only, not individual investment advice or recommendations. Sungarden provides Advisory Services through Dynamic Wealth Advisors.