Please Practice Portfolio Distancing!

By now, we all know that wearing masks and practicing social distancing is the responsible way to go about our daily business. Financial markets are taking a different stance during the pandemic. A “safety in numbers”, herd mentality has driven everyone into the same securities and investors are currently buying Amazon stock with the same intensity that they bought Clorox wipes from the Amazon website in April.

The result is that index concentration has risen to extreme levels with the largest five stocks in the S&P 500 now comprising 21.7% of the index (Figure 1). This concentration is even higher than it was at the height of the DotCom bubble.

Concentration problems are compounded because these five companies are technology-related meaning that their share prices could be affected were a shock to occur in a technology-related business risk. For example, supply disruption in Asia or more restrictive data privacy regulations in the US.

Figure 1. Weight of top 5 positions in the S&P 500
Total weight of largest 5 companies in the S&P 500, 12.31.1991-6.30.2020. Weights labeled on 3.31.2000 and 6.30.2020. Source: S&P Dow Jones Indices, Syntax

IT and Information stocks currently comprise 46.5% of the S&P 500 (Figure 2), close to their index weight in March 2000 (46.9%). The poor performance from technology stocks after the DotCom bubble burst, combined with the oversized weight of the two sectors caused the aggregate S&P 500 index to fall (-3.2% annually for the next 5 years). If all sectors were given an equal weight in March 2000, the S&P 500 would have had a positive return over the same period (+0.7% annualized). That is, the impact of the tech shock should have been contained in much the same way that the spread of the virus should be contained by socially distancing groups of people.

Figure 2. Weight of IT and Information sectors in the S&P 500
Combined weight of the IT and Information sectors in the S&P 500, 12.31.1991 to 6.30.2020. Weights labeled on 3.31.2000 and 6.30.2019. Source: Syntax, S&P Dow Jones Indices

We believe that the recent strong performance of the largest companies has given investors in these stocks a false sense of security. The big five companies are up 25% for the first half of 2020, which is particularly strong performance given that the average stock is down 10.8% over this period. The strong performance follows significant outperformance in 2018 and 2019 (Figure 3) but is unusual given that the largest five companies have underperformed the equally weighted S&P 500 significantly (by 2.5% per annum since 1992). 

Of course, concentrated portfolios are easy to live with when they are outperforming, as has been the case for the S&P 500 (versus alternatively weighted indices, such as equal weight). However, we caution that the strong momentum and outperformance of the largest companies is similar to that seen during the DotCom bubble. During that episode, problems began to occur when the market woke up to the realization that valuations were factoring in unrealistic growth assumptions. When companies failed to meet their earnings expectations, a crowded exit caused prices to dramatically correct (Figure 4).

Figures 3 & 4. Performance of top 5 companies versus the S&P 500 Equal Weight index
Performance of the S&P 500 Equal Weight Index versus the largest 5 stocks in the S&P 500 from 12.31.2012 to 6.30.2020 and 12.31.1992 to 3.31.2001 (equally weighted, rebalanced monthly). Dashed lines indicate performance of the S&P 500 Equal Weight Index and of the largest 5 stocks in the S&P 500 following the market peak in March 2000. Performance does not reflect fees or implementation costs as an investor cannot directly invest in an index. Source: Syntax, FactSet, S&P Dow Jones Indices

Though the earnings of large cap technology stocks have been largely resilient to the pandemic, there are signs that prices have detached from fundamentals. Microsoft delivered stronger than expected second quarter revenues and earnings. However, its share price declined on the day of the announcement. suggesting some nerves around the 35x earnings multiple that the stock commands.  Concerns around Q2 results season are further amplified due to the increased antitrust focus that the largest tech stocks are currently facing.

The Syntax Stratified LargeCap index avoids taking crowded positions in stocks or industries by directly diversifying business risk. This portfolio distancing approach reduces the impact that economic shocks have on the index as a whole.

By investing widely across all business opportunities, the Stratified approach avoids taking expensive momentum positions and a disciplined quarterly rebalancing schedule helps retain the strategy’s value stance. The valuation differential to cap weighted products is at a ten-year discount, with the Stratified LargeCap trading at 2.5x book value and 19.4x forward earnings, versus 3.4x book and 24.9x forward earnings for the S&P 500.

Just like everyone knows that we need to wear masks to stay safe, everyone knows that diversification and valuation are important considerations when constructing investment portfolios. However, the most widely followed benchmarks, like the S&P 500 or Russell 1000, are currently violating these principles. For me, the thought of not wearing a mask in public is more risk than I am comfortable with, especially given the small price to pay for the insurance. By herding into the same securities, investors are taking more risk than they realize. History has shown that the largest companies in the index usually underperform the broad index, especially in periods when valuations become stretched. A more diversified approach such as Stratified Weight distances investors from these risks.

Important Disclaimers

Past performance is no guarantee of future results. Charts and graphs are provided for illustrative purposes only. 

This presentation is for informational purposes only and is not intended to be, nor should it be construed or used as an offer to sell, or a solicitation of any offer to buy, any security. Additionally, the information herein is not intended to provide, and should not be relied upon for, legal advice or investment recommendations. You should make an independent investigation of the matters described herein, including consulting your own advisors on the matters discussed herein. In addition, certain information contained in this factsheet has been obtained from published and non-published sources prepared by other parties, which in certain cases have not been updated through the date hereof.  While such information is believed to be reliable for the purpose used in this factsheet, such information has not been independently verified by Syntax and Syntax does not assume any responsibility for the accuracy or completeness of such information. Syntax LLC, its affiliates and their independent providers are not liable for any informational errors, incompleteness, or delays, or for any actions taken in reliance on information contained herein.

The Syntax Stratified LargeCap Index (“the Index”) is the property of Locus Analytics, LLC, which has contracted with S&P Opco, LLC (a subsidiary of S&P Dow Jones Indices LLC) to calculate and maintain the Index. The Index is not sponsored by S&P Dow Jones Indices or its affiliates or its third party licensors (collectively, “S&P Dow Jones Indices”). S&P Dow Jones Indices will not be liable for any errors or omissions in calculating the Index. “Calculated by S&P Dow Jones Indices” and the related stylized mark(s) are service marks of S&P Dow Jones Indices and have been licensed for use by Locus Analytics, LLC. S&P® is a registered trademark of Standard & Poor's Financial Services LLC (“SPFS"), and Dow Jones® is a registered trademark of Dow Jones Trademark Holdings LLC (“Dow Jones”). Syntax®, Stratified®, Stratified Indices®, Stratified WeightTM, and Locus® are trademarks or registered trademarks of Syntax, LLC or its affiliate Locus, LP. 

Index performance does not represent actual fund or portfolio performance and such performance does not reflect the actual investment experience of any investor. An investor cannot invest directly in an index. In addition, the results actual investors might have achieved would have differed from those shown because of differences in the timing, amounts of their investments, and fees and expenses associated with an investment in a portfolio invested in accordance with an index. None of the Syntax Indices or the benchmark indices portrayed herein charge management fees or incur brokerage expenses, and no such fees or expenses were deducted from the performance shown; provided, however that the returns of any investment portfolio invested in accordance with such indices would be net of such fees and expenses. Additionally, none of such indices lend securities, and no revenues from securities lending were added to the performance shown.  

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