In March, market interest rates, which are set by buyers and sellers in the bond market, continued their rapid rise from year-end 2020, with the ten-year US benchmark rate increasing from 0.93% to 1.74%. But even in the face of these rising rates, stock prices continued to advance. Since we have discussed rising rates, inflation, and their impact on bond and stock prices over the last few months, we thought we would change our focus this month to a more detailed look at results for different parts of the stock market.
The financial media most often reports stock price results based on the changes for a few key stock market indexes, namely the Dow Jones 30 Industrials (DJI: most of the 30 largest US companies by market price per share), the S&P 500 (almost all of the 500 largest US companies by market value, which is price per share times shares outstanding), and the NASDAQ Composite (the largest 2,500 companies by market value that trade on the NASDAQ exchange).
At Park Piedmont, we also consider stock price results and changes of these indexes, and use a Total US Stock Market index as a proxy for the entire US market when we do our stock investing. That said, a rather extraordinary and unusual event occurred with stock prices in the year 2020, as the NASDAQ gained 43.6%, the S&P 500 rose 16.3%, and the DJI increased by a more modest 7.3%. The Total US Stock Market index gained 21.0%, as might be expected from an index designed to reflect the combined results of these other three indexes. (All of these annual/annualized results, going back to 1999, are reported in our Comments each month, typically on page 5, with the specific page dependent on the length of our commentary starting on page 2.)
To better understand the huge disparity, note that almost all of the giant technology stocks are traded on the NASDAQ exchange and are therefore included in that NASDAQ Composite index. While most of these stocks are also included in the S&P 500 index, the S&P 500 includes many more stocks from other parts of the stock market. The DJI index, by contrast, consists of only 30 stocks, so that underperformance (or outperformance) by a few has an outsized impact on any period’s results. The S&P 500 exchange traded fund (ETF) (symbol SPY) has been divided into eleven sectors, each of which can be bought and sold separately from the broad-based SPY. Those sectors are, in order of their current relative valuation in the total SPY: Information Technology, Health Care, Financials, Consumer Discretionary, Communication Services, Industrial, Consumer Staples, Energy, Utilities, Reals Estate, and Materials.
The obvious question is, why not change to the NASDAQ at some time during 2020, or at least at the start of 2021, given its significant outperformance in 2020? The fundamental answer is that no one can know in advance of the outcome which part of the stock market is going to outperform the other parts. Only in hindsight is it clear which have been the best performers in any time frame. To invest by selecting what you believe will be the outperformers is essentially market timing, risking the chance of having selected the underperformers as time passes. A perfect example of this risk was the first quarter (Q1) of 2021: the DJI gained 7.8% and the NASDAQ 2.8%. The 2020 star was the laggard for Q1 2021. Also, during Q1 2021, the more broadly diversified indexes of the S&P 500 and the Total US Stock Market gained 5.8% and 6.4%, respectively, once again occupying the middle ground between the Dow and the NASDAQ.
There are other ways of subdividing the stock market into indexes broad enough to establish meaningful diversification − namely, International/ Emerging Market stocks compared to US stocks; Growth stocks compared to Value stocks; and Mid-Cap/Small-Cap stocks compared to Large-Cap stocks. Some of this discussion may become more detailed than you would prefer, so please contact us with questions.
Investing in International/Emerging Market stock indexes does provide access to the rest of the world’s stocks and their stock exchanges, which sometimes move in substantially different directions than the US stock indexes do. While US indexes contain some companies with significant international businesses, investing internationally can provide real diversification, and Park Piedmont typically allocates portions of clients’ stock portfolios in this way.
Growth and Value refer to differences in the Price/Earnings (P/E) ratios of component stocks in the various indexes. You may recall that the P/E ratio captures in one number the market price per share of a stock as it relates to that company’s earnings (profits) per share. The higher the P/E, the higher the market price will be relative to that company’s earnings. Growth stocks typically have higher P/Es than Value stocks, as investors/traders are willing to pay more for what they believe will be higher future earnings growth rates. Companies characterized as Growth or Value stocks will likely almost all appear in the broadest-based indexes, such as the S&P 500 and US Total Stock Market. For example, Apple, with a 35 P/E at $130 per share, is in the Growth index, while Verizon, with a 13 P/E at $57 per share, is in the Value index. There can be major divergences between the Growth and Value indexes. During 2020, for example, Growth rose 40.0% and Value only gained 2.2%, with the tech outperformance cited above reflected in the Growth results. In Q1 2021, Value outperformed Growth by 10.9% to 1.5%, reflecting the (short-term, at least for now) reversal of the 2020 disparity.
Large-Cap/Mid-Cap/Small-Cap is another meaningful way to divide the stock market. These terms refer to the size of a company measured by its market value. Market value is determined by multiplying the price per share of a company by the number of shares outstanding. The result is also known as the company’s market capitalization, or “cap” for short. Large companies (Large-Cap) have market values in excess of $20 billion; Apple has recently made it to $2 trillion and is still the highest currently-valued stock. Mid-Cap stocks tend to have valuations between $10 and $20 billion, and Small-Cap under $10 billion. In the current bull market starting March 2020, valuations of most companies have gained, so the value ranges related to size vary. In 2020, the Mid-Cap and Small-Cap indexes gained almost the same, at 18.2% and 19.1%, respectively, whereas Large-Cap (S&P 500) rose 21.0%. The stocks in these three size indexes can have a Growth or Value emphasis.
The various ways to divide the stock market have spawned an industry of their own, using sector/style ETFs in an effort to identify outperformers and avoid underperformers. Our purpose here is not to give you information to become a market timer, but rather to provide an initial idea of the complexities. We suspect most of you have better things to do with your time, and this applies to PPA as well. We focus on the broadest-based indexes, which include most of the stocks from the various subsets of the stock market discussed above. We also believe in “regression to the mean,” in which one period’s winners are frequently a subsequent period’s losers.
Once again, please note the chart of results on page 5 below, which demonstrate the highly variable results of different parts of the market over time. Picking winners and losers correctly on any regular basis is almost impossible, and most often ends in chasing past performance − that is, buying the outperformers just as they are about to underperform. That is why we at PPA focus on the broadest-based indexes and avoid the lure of market timing.
Please let us know if you’d like to discuss these topics further. We are here to be a resource, and to help you, our clients, continue to gain knowledge and comfort in this subject matter.