August 2018

Weekly Commentary August 24, 2018

In a Time of Tech Dominance, It Still Pays to Diversify
By Tim Courtney, Chief Investment Officer

When people talk about how the “stock market” is doing, they typically mean the performance of the S&P 500¹ or Dow Jones² indexes. If an investor hears the market is trending up or down, he or she might think that’s reflective of the average company being tracked. In reality, it doesn’t work that way.

Only a handful of companies (about a quarter to a third of companies in the market) usually are responsible for the growth in the market in any one year while the remaining stocks tend to sit idly¹. That said, it’s not always the same stocks driving the market forward. Various industries and companies dominate for different stretches, but in general, the market’s growth is reliant on about 25 percent of its companies at any given time³.

While it’s typical for a minority of stocks to be leading the market, what is so unusual year-to-date is just how small that minority is. Through mid-July, the so-called FAANG stocks (Facebook, Amazon, Apple, Netflix and Google) and five other technology/financial technology stocks⁴ like Nvidia, Adobe and Mastercard were responsible for nearly the entire S&P 500 return⁵.

Using the 25 percent rule, we would expect about 125 companies in the S&P to be driving the market at any given time, but recently that number has been about 10. We last saw this scenario occur in 2015, when a few tech companies pulled the entire market just above the waterline while most other sectors were weak and faltering⁶.

A more worrisome comparison is when tech was at the forefront from 1998 to 2000, leading to the “dot-com bubble” bursting and a massive market decline⁷. Fortunately, we don’t foresee a replay of these events on the horizon. Today’s technology companies are much more fundamentally sound, are trading at much lower valuations and have more free cash flow⁸.

However, these time frames are similar in how the market became so focused on the technology sector. For example, many financial companies have posted strong earnings recently but the financial sector has barely moved⁹. History has tended to reward investors who purchase assets at attractive prices, and we think that will happen again as the market broadens its attention.

We believe the tech sector certainly merits investment and is now the largest sector of the S&P 500 at roughly 23 percent¹⁰. However, expectations for many of these companies are quite high and the market will likely not be forgiving if earnings are off target (see the market’s recent reaction to Chinese tech company Tencent’s earnings miss)¹¹.

That’s why we recommend resisting the urge to focus investments in a particular sector and maintaining a diversified portfolio across multiple sectors that are made up of many profitable and growing companies as well.

Sources:

1. Yahoo! Finance – S&P 500
2. Yahoo! Finance – Dow Jones Industrial Average
3. DFA Study
4. Investopedia – FAANG stocks
5. Forbes – The plot narrows: A smaller number of stocks are driving the index, and that’s not good
6. MarketWatch – 2015 year in review: The S&P 500’s winners and losers
7. Investopedia – Market crashes: The dotcom crash (2000-2002)
8. Zacks Investment Research – One big reason why tech stocks are not in the ‘dot-com bubble’
9. The Motley Fool – Fantastic earnings from these two investment banks
10. CNBC.com – Tech dominates the S&P 500, but that’s not always a bad omen
11. Investor’s Business Daily – China internet stocks hammered as Tencent earnings show surprise miss

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