This week the S&P 500 hit an all-time high, erasing the 35.41% drop earlier this year and marking the fastest recovery from a 30% decline. This rise should come as no surprise since the decline into bear territory was also the fastest on record. Markets are adjusting quicker than they have in the past.
With so much uncertainty in the economy, is the market suffering from “irrational exuberance”? To answer this question, one must take a deeper look into what is really happening in the stock market. Although the S&P 500 is reaching new highs, the breadth of the rally has been narrow with many stocks not participating. In fact, there has been a huge divergence in the market. Highlighting the current schism is the difference in returns for value and growth stocks. Year to date, large cap growth stocks have returned over 21% while large cap value stocks have declined almost 10%. That’s a return differential of over 30 percentage points. Quite a difference!
To date, there are a number of industries that are still performing poorly. The worst performers are department stores, airlines, travel services, oil and gas equipment and services, resorts and casinos, hotel and motel real estate investment trusts. These industries are all off about 50% for the year. The next worst performing 15 industries are not doing much better. They are off over 30%.
So what stocks are working? Let’s take a look at the five largest stocks of the S&P 500. They are Microsoft, Apple, Amazon, Google parent Alphabet and Facebook. Year to date, Microsoft is up over 50%, Apple is up close to 60%, Amazon has jumped more than 70%, Google has gained more than 30% and Facebook has climbed nearly 30%. In the face of the pandemic, do these gains make sense? Well, if you look at their income statements, you’d be hard pressed to see signs of the economic downturn, quite the contrary. Besides Google, revenue and earnings growth is strong. To be fair, Facebook’s earnings growth has been boosted because of one time charges taken in 2019. These five companies alone account for more than 22% of the market cap of the entire S&P 500 index, so their performance has an outsized effect on the S&P 500.
And because the S&P 500 is a market capitalization weighted index, the larger companies have a more profound effect on the overall movement of the S&P 500. As a matter of fact, of the 500 companies in the S&P, about 50 of them are doing well, while 450 are performing poorly so far this year. Many of the well-known and highly visible industries, like airlines, hotels, travel, and retailers, do not comprise a large portion of the S&P 500 so their performance has only a minor effect of the performance of the Index. On the other hand, the technology sector is the largest sector in the S&P 500 and accounts for over 20% on the Index. Looking at year-to-date returns for the 10 largest technology companies, if you equally weighted these stocks, they would be up about 40%; however, the remaining 490 names would be off over 7%.
Given the drop in economic activity and the uncertainty going forward, does it make sense that 450 companies are doing poorly? I think we all would agree that the answer is yes. On the other hand, as discussed above, for companies thriving during this period, would it make sense for their stock prices to be depressed? I think we all would agree that the answer is also yes.
Over the long term, fundamentals drive stock prices, but over the short term emotions play a major part. Right now, investor sentiment is elevated by the possibility of a vaccine in the near term. Beyond that, there are a number of reasons why the stock market and the economy do not move in the same direction. Markets look through the present and anticipate the future.
Helping them look through the present economic problems, as we have noted in the past, is the fact that the Fed and Congress injected unprecedented stimulus into the economy, totaling nearly 21% of GDP. At the same time, the Fed has lowered interest rates to near zero. This has added a lot of money into the system and a good portion of it ends up in the market. The adage “Don’t fight the Fed” comes to mind and it’s usually right.
To conclude, I think it is reasonable that the stocks of companies that are doing well during this pandemic have rallied and that the stocks of companies that are struggling have seen their prices struggle, as well. Does this mean that I think the market is properly priced? Not at all, but I bristle at the thought that the collective wisdom of investors is irrational. While I think investors do get too optimistic and too pessimistic at times, I feel it would be arrogant of me to think that I know better.
Washington Trust Bank believes that the information used in this study was obtained from reliable sources, but we do not guarantee its accuracy. Neither the information nor any opinion expressed constitutes a solicitation for business or a recommendation of the purchase or sale of securities or commodities.
Washington Trust Bank.