The market’s off to a great start for 2017, with the S&P 500 up 7.9%. Not too many investors are trumpeting their outperformance. That may be a good thing for those underperformers.
What? It’s not good to be beating the market? When a market is this narrow and concentrated, outperformance may be inconsistent with every important investing tenet.
Nearly 60% of the S&P 500’s return this year is the work of just five stocks: Apple (AAPL), Alphabet (GOOG), Microsoft (MSFT), Amazon (AMZN), and Facebook (FB). Some call them the FAANGs.
What’s more, all five are techs, and four of the five have over half their revenues from a single source: Facebook, 97% from online ads; Alphabet, 88% online ads; Amazon, 72% online products; and Apple, 63% iPhones.
Absent being overweight in these five names, a market beating quest is most likely coming up short! Should you chase these names now?
In a Nutshell
Most investors are underperforming the S&P 500 this year. The market is being driven by just a handful of mega cap techs. To focus simply on these stocks is too risky.
A very narrow approach, although it may provide temporary bragging rights, violates the most important tenet in investing: Diversification. The prudent approach is not to focus on a narrow group of similar stocks, but rather to strive for exposure to a wide range of investments.
Those wishing to chase the current market should study the rise and fall of big cap tech in the late 1990s.
Although many of these companies now leading the S&P 500 brigade are indeed developing next generation technologies, their stock prices reflect that. The future gain, if they live up to the hype, may be less than the downside should they become old tech.
Underscoring that the market is being led by such a small tech cohort is the gap that has now developed between tech and the rest of the market. The overall S&P 500 has risen nearly 18% in the last year to 4/30/17; techs have soared over 31%.
That size disparity is seen only 8% of the time. That gap is typically associated with a market in transition, from bull to bear or vice versa.
This year S&P growth stocks are up 12.9%, while value stocks are up just 2.2%, an unusual double-digit difference. This further confirms the unevenness of the market’s advance. Despite the market trading at new highs, fully 40% of all stocks are trading below their 50 day moving averages.
Economic theory suggests that capital keeps moving to favored areas until higher prices curtail the potential for excess profits. Experience reminds us that disparity in the returns of various cohorts of stocks are like rubber bands; they can stretch only so far until they snap back, sometimes violently.
Diversification is the Key to Reducing Risk
The most important tenet of investing is diversification. By mixing into your portfolio investments that have a low degree of correlation, an unforeseen development is less likely to have too large portion of your portfolio moving in a negative direction.
The current market might tempt some to overweight internet stocks, online retailers, techs and growth stocks in an attempt to generate fast, easy profits. Many are doing that now, as inflows into techs are at a 15 year high.
Unfortunately, common sense and investment history counsel that this, too, shall pass. Investors discarding classic diversification strategies will not obtain the returns they expect for the risks being embraced.
Value Investing Reduces Risk
Value stocks’ appeal is based on their greater dividends and cheaper prices relative to their earnings, sales, and cash flow. Fidelity’s study of growth versus value over a 31 year period concluded that large capitalization value stocks outperformed their growth counterparts by about 1.8% annually.
Dividend paying stocks are historically more resilient during down turns. The dividend yield rises as the stock price slumps, attracting income oriented investors as well as traditional bond investors.
One more reason to be cautious about chasing the FAANGs now is that they are anything but value. The Nasdaq Internet Index trades at a whopping 34 times forward earnings, versus a more reasonable 18 times for the overall S&P 500.
Do today’s FAANGs have seemingly bright futures? Of course. Still, you ignore their current valuations at your peril.
Sectors That Do Make Sense
What are today’s anti-FAANGs? Energy, commodities including gold, financials, pharmaceuticals, and overseas stocks have been out of favor for years, and sport much lower valuations. With interest rates still at extraordinary lows, investors will continue to look for more productive investments than fixed income.
Note: David G. Dietze, JD, CFA, CFP™ is President and Chief Investment Strategist of Point View Wealth Management, Inc., a registered investment advisor at 382 Springfield Avenue, Summit.
CNBC has named Point View to its list of the top 100 fee-only wealth managers in America! See http://www.cnbc.com/2015/06/03/cnbc-charts-the-top-100-firms.html
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