Many investors have likely seen stories or headlines about massive U.S. companies making up a disproportionately large share of the U.S. stock market. For instance, maybe you’ve seen this statistic, or one like it, before: as of December 31, 2021, the 10 largest stocks in the S&P 500 accounted for 30% of the index’s total value. In other words, just 2% of large-cap U.S. companies account for 30% of the benchmark large-cap index.1
The concern that follows is also quite common – is the stock market too concentrated, with the index’s performance ultimately being decided by just a handful of companies?
Let’s consult the data. Over the past five years, the influence of the biggest companies has been apparent: the annualized performance of the S&P 500 (which is market-cap-weighted, meaning the biggest stocks have more influence) was +18.47%. But if you weigh all 500 companies equally instead of by market cap, the annualized performance drops to +15.73%. On an annualized basis, the roughly 3% spread is significant.
However, if you zoom out further and compare the 20- and 30-year annualized returns of a cap-weighted versus an equal-weighted S&P 500, here’s what we find:
- 20-year annualized S&P 500 returns:
- Market-cap-weighted: +9.51%
- Equal weighted: +10.86%
- 30-year annualized S&P 500 returns:
- Market cap weighted: +10.64%
- Equal weighted: +11.92%2
Big companies having a big influence over the index is a relatively new phenomenon. Five of the biggest S&P 500 companies – Apple Inc., Microsoft Corp., Nvidia Corp., Alphabet Inc. (Google), and Tesla Inc. – accounted for roughly one-third of the S&P 500’s +28.7% return last year. This trend is significant short-term, but long-term, the data suggests capital will eventually rotate from high valuation (growth) to low valuation (value) names.
In 2022, there is a key factor to consider, which is that the Federal Reserve now appears likely to start increasing interest rates in the first quarter of this year and to begin trimming its ~$9 trillion balance sheet perhaps by summer. Higher interest rates and generally tighter monetary policy could create some headwinds for high valuation stocks, including some of those that reside at the top of the S&P 500 by market cap. Since many high valuation names arguably trade at high multiples because the discount rate for future earnings is so low, a higher discount rate makes future earnings less valuable today.
For investors, the insight here is that active management will be important in 2022, in my view. At Zacks Investment Management, we use research to drive all of our decisions, and we’re actively managing portfolios to ensure every stock is generating strong cash flows, maintaining solid gross profit margins (particularly in an inflationary environment), and delivering better-than-expected earnings consistently. I think this analysis will be even more crucial in 2022, with earnings growth rates coming back to Earth as seen in the chart below.
Zacks Investment Research3
In the past 10 years or so, capital has rotated quite a bit away from the value and small-cap stocks and towards growth and large-caps, generally speaking. Much of the growth surge happened because of technology’s continued rise, which accelerated greatly during the pandemic. Each of the five stocks I mentioned at the start of this column is riding that wave.
I think the question from here becomes whether capital – particularly in a rising interest rate environment – starts to rotate into other areas of the market that are now trading at a discount. The S&P 600 (an index of small-cap stocks), for example, currently trades at about 15x forward earnings, which makes small-cap stocks about 30% cheaper than their large-cap counterparts. Mid- and large-cap value stocks also look increasingly attractive on a relative basis.4
2022 may be set up as a year where some of the market’s concentration in high valuation stocks and a limited set of names gives way to capital rotation into undervalued companies that still generate strong earnings and cash flow. For investors, I think that means stock selection and active management – which is our focus at Zacks Investment Management – will be key in 2022.
Bottom Line for Investors
For all the earnings and growth volatility generated by the pandemic over the last two years, the U.S. stock market has charged ahead. In 2021, equity investors who stayed the course likely experienced above-average returns with below-average volatility – certainly not what you might expect in a year as bizarre as that one.
I do not think the stock market is poised to do poorly in 2022 or that the risk of recession is high. But because earnings growth faces tough comparisons – and because the Federal Reserve will be tightening monetary policy throughout the year – I think careful stock selection will be a priority. Our research-driven process and disciplined approach should serve us well.
1 Washington Post. January 3, 2022. https://www.washingtonpost.com/business/the-stock-market-is-too-narrowly-focused/2022/01/03/e6648a12-6c95-11ec-b1e2-0539da8f4451_story.html
2 Bloomberg Data. January 10, 2022.
3 Zacks. January 5, 2022. https://www.zacks.com/commentary/1848033/handicapping-the-q4-earnings-season
4 Seeking Alpha. January 6, 2022. https://seekingalpha.com/article/4478296-while-growth-collapses-look-here-for-undervalued-stocks-which-will-continue-to-thrive-in-2022
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