After registering the swiftest 35% decline on record, the S&P 500 — a stock market index that measures the stock performance of the 500 largest U.S. publicly traded companies — has rallied more than 25% and now sits only about 15% from its most recent all-time high. Many are wondering how the market could be performing so well in the face of COVID-19 and the resulting economic shutdown. There are a few points to consider on this matter:
- There is always some symmetry to “relief rallies”. Because the stock market decline was so dramatic, it is not entirely unexpected that the rebound would be equally sharp.
- Many believe that the depths of the sell-off were exacerbated by ‘forced’ selling into illiquid markets.
- The immediate and sizeable reactions from governments and central banks undoubtedly facilitated the recovery of the stock market. Stimulus packages and stay-at-home orders have helped to at least partially mitigate the risk that this health crisis could evolve into a full-blown public health catastrophe or long-term economic depression.
- There are tangible signs of improvement when it comes to the spread and severity of the Coronavirus as economies start to develop re-opening procedures.
However, another contributing factor to the recent rally that is less well understood and could serve to limit future downside is simply how the S&P 500 is constructed. By breaking down which stocks have led the rally and which continue to lag, we can begin to understand recent performance and how the stock market average (i.e. in this case, the S&P500 index) is not representative of the average stock.
Currently, nearly 35% of the value of the S&P 500 is represented by just 20 stocks – that’s just 4% of the companies included in the index. The five largest companies at present — Microsoft, Apple, Amazon, Google and Facebook — account for about 20% of the index’s value. This is the highest level of index concentration in over 40 years. Further, during this market rally, these 20 companies have generated approximately 35% of the index’s total return.
Rounding out the top 25 index constituents are mainly companies in health care (Merck, Pfizer, UnitedHealth), telecommunications (ATT, Verizon), consumer staples, (Walmart, Pepsi, P&G), and technology (Intel, Visa, Mastercard, Cisco, Netflix) with only one company in the Energy sector (Exxon).
These companies are, for the most past, expected to see little-to-no lasting long term impact from the economic lockdown. Amazon’s business model is almost certainly more valuable today than it was two months ago. People are using Facebook (and their associated properties) more during the quarantine, not less. Google should be able to take even more share of the advertising market as more businesses introduce online sales channels in a post-COVID world. And there will be more general awareness and demand for the health care products that J&J produces. This is why we are happy owners all four of these excellent companies.
Broadly speaking, the S&P500 is dominated by companies with resilient business models, strong balance sheets, access to capital and high barriers to entry in sectors that are less sensitive to one-off economic shocks. These are, in short, the largest and best positioned companies in the world. Even the smaller constituents of the S&P500 index are better able to weather this storm when compared to smaller capitalization stocks not big enough to be included in the index (as evidenced by the relative outperformance of large cap versus small cap stocks) and certainly more so than small independently owned businesses which are struggling to stay afloat.
Shares of Larger Companies are Significantly Outperforming Those of Smaller Ones
The divorce between the large, steady winners and the rest of the market has become very apparent over the past several weeks. While the S&P 500 was down only about 14% from its all-time high (as of April 30), the median stock in the index was down nearly 30%. The dispersion between the top and bottom performers has exploded to levels not seen since the last two recessions, a common phenomenon of market sell-offs.
So, now that we are here, what can we make of this situation and is there anything to take away? Fortunately, volatility does create opportunity. Periods of high return dispersion amongst individual stocks such as we are seeing now have historically been good for active stock picking as they are fertile ground for managers to find investment opportunities that can meaningfully outperform the average.
Return Spread Between the Best and Worst Performing Stocks
In this vein, we expect that high-quality, well-capitalized companies with business models that are being somewhat impacted by the pandemic may begin to outperform the broader market as we emerge from the lockdown and investors realize that those businesses will start to benefit from an earnings recovery. Should this occur, it would not be surprising to see certain companies that have been relatively immune to COVID and performed well to date become tomorrow’s laggards.