by Ned Montag, CEO
Mark Twain has many great quotes. Among them is: “There are lies, damn lies, and statistics.” Twain knew that mathematically accurate numbers could give false impressions, either on their own or by a clever soul with an agenda. A great example is found with today’s S&P 500 Index. The index can be weighted multiple ways, but the most common method is usually as “capitalization weighted” – also known as the cap weighted index standard.
The “cap weighted” Standard and Poor’s 500 Index is ubiquitous in our field and across the globe, constantly used by news sources and investors of all types. Most of the time, the calculation, either up or down, reasonably corresponds to what most investors will experience in their own portfolios. But, for the fifth time in the past 50 years, that pattern has been broken.
What Is The Role Of The Cap Weighted Index?
The “cap weighted” S&P 500 calculation, by definition, gives far greater computational weight to the most highly valued companies in the index. Generally, those companies perform roughly in line with the many smaller members of the index, and the index value corresponds to trends in the broad stock market. But when, like now, a few of the largest companies massively outperform the smaller index members, the index calculation can vastly overstate any gains being made in the broader market. And this can distort investor experience.
Currently, five of the largest S&P 500 components are Apple, Microsoft, Amazon, Alphabet (Google), and NVIDIA. Those five, particularly NVIDIA, have risen far more than the other 495 members of the index. As a result, by the end of June, these five big gainers (only 1% of the 500 stocks) represented approximately one quarter (25%) of the total value of the 500-stock index. Apple alone is worth 7.5% and is now valued at $3 Trillion. In fact, by the end of May, only 25% of the 500 stocks in the index had actually beaten the index average. By late June, this “cap weighted” index was up 16% for the year, but the average stock in the index was up only 4-5%. For any manager who built a diversified portfolio putting roughly equal dollars in each holding, performing in line with the cap weighted S&P 500 would have been close to impossible.
Example Of The Cap Weighted Index In Use
Assume, solely for illustration, that you make a “cap weighted” index out of just two stocks, Apple and CVS. At the end of May, Apple stock had a total market value (number of shares times share price) over $2.5 trillion. At the same time, the total market value of CVS was about $90 billion.
Next, assume that you or your manager own equal dollar amounts of both Apple and CVS, consistent with most professional practices. On Day 1, assume that Apple’s stock price rises 1%, and CVS stock declines 1%. If you own them in equal amounts, the change in dollars on Day 1 is zero.
However, the two-stock “cap weighted” index would calculate that Apple’s value increased $25 billion (1% of $2.5 trillion) and that the value of CVS fell $1 billion (about 1% of $90 billion). The net result is that this cap-weighted index value increased by $24 billion. A very different result, up almost 1%. It does not “break even” as did the equal-weight portfolio. (In fact, this result concentrates you deeper into one stock. Hmm.)
Now let’s make it interesting. On Day 2, assume Apple stock rises 4%, but CVS stock, for some reason, falls to zero, a total wipe-out. Your equally invested portfolio would lose almost half its value. Ouch.
The “cap-weighted” index would compute a market value gain from Apple of $100 billion countered by a market value loss from CVS of $89 billion. Remarkably, this results in a net gain of $11 billion for the index! This is a very different result from the equal weighted portfolio.
This example is unrealistic, but vividly shows how the performance of a few highly valued stocks in a “cap weighted” index can mislead investors concerning broad market trends.
This extraordinary imbalance in performance in the index is generally rare. There have been four previous times since 1972 when this occurred: “Nifty Fifty” growth stock mania which popped in 1973, an oil stock mania in 1979-80, the Internet stock bubble of 1999-2000, and the COVID lockdown of 2020.
In each and every case, the imbalance reversed within the next year, and many smaller company stocks that had underperformed during the mania went on to outperform their big company brethren. We are seeing a large valuation disconnect between the handful of technology darlings and the rest of the market, and history suggests that the neglected smaller company stocks could be catching up sometime during the next 12 months. Stay tuned.
Finally, none of what we have discussed is a criticism of the cap weighted S&P 500 Index. Its calculations are accurate, and its methodology is public knowledge. We merely note that, for now, the index’s performance is considerably overstating the performance of most stocks in the U.S. so far this year.
We thank you for your business and your trust.
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The information provided is for illustration purposes only. It is not, and should not be regarded as “investment advice” or as a “recommendation” regarding a course of action to be taken. These analyses have been produced using data provided by third parties and/or public sources. While the information is believed to be reliable, its accuracy cannot be guaranteed.
Any securities identified were selected for illustrative purposes only. Specific securities identified and described may or may not be held in portfolios managed by the Adviser and do not represent all of the securities purchased, sold, or recommended for advisory clients. The reader should not assume that investments in the securities identified and discussed were or will be profitable.
