Why The S&P 500 Isn't What You Think It Is

 

Summary:

  • The S&P 500 index is size-weighted. A $100 billion company enjoys 10 times the influence over the index as a company whose market capitalization is $10 billion.
  • The top 5 companies consume more than 14 percent of the index, equivalent to that of the bottom 265.
  • The companies in the index are added and removed by real live people.
  • The historical turnover is 4.4 percent, or approximately 22 changes each year.
  • While it feels like today’s top 5 companies can do no wrong, history suggests this dominance is unsustainable.
  • The biggest gains will come while on the journey to the top, not after arrival.
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How to Predict the Market Like the Experts

 

The highly unlikely 2017 and the more typical 2018 that has followed has me contemplating the difficulty of forecasting how the market will do in the future.  I don’t remember anyone anticipating, in December 2016, a banner year in 2017 via a nice straight line.  Indeed, predicting any given future year’s stock market performance is very difficult, but why don’t you try!

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2018 Isn't That Volatile: Studying the Black Swan of 2017

We can’t help but contemplate unlikely events, both good and bad. When you buy a lottery ticket, you know you will almost certainly not win, but you enjoy the minute-long fantasy of what you would do if you did win. The Tigers could get something going this season and win the World Series, says a hopeful sports analyst on the radio. The medical website shows that your symptoms indicate seasonal allergies, but it could be the rare disease that killed a man last year. There are many books in the world of investing, but many of the bestsellers are about the huge losses that most people thought were impossible. We call these unlikely scenarios extreme tail events or black swans.

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Shuffling the Sector Deck

 

Have you heard about the ivory tower academics who unilaterally made a huge decision affecting billions of dollars last year? To make matters worse, if investors fall into the trap of trading like automatons, this will trigger untold millions in taxable gains in the process!!! I presume you hadn't heard about this investment earthquake, but I bet I have your attention now.

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The Latest Hammer to Smash the Market's Thumb

 

We spend much of our time in our writings here discussing high level topics like the importance of financial plans, why working with a fiduciary is so valuable, and the traps of behavioral finance. Rightfully so, as these are the big decisions we need to get right to achieve our goals. Nonetheless, I expect most of our readers go a level deeper in their interest and keep track of the stock market (and maybe the bond market) over long periods of time, and we write on broad market behavior now and then to help articulate what we see in our research. Sometimes, though, the market watchers among us notice market movements like we experienced at the beginning of this month and wonder "why the heck did that happen?!" Completely answering that question is almost impossible, but I believe two things:

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The Market Has Done Worse Than You Think

When speaking with clients, peers, and friends alike, there are some common questions: "When will this bull market end?" or "It's too late to buy stocks, right? They have to go down from here." Sometimes they even use the word "bubble!" The short answer is: I have no idea and anyone who tells you they do is probably lying, misguided, or foolish. The long answer is more complicated, and involves taking many factors into consideration, especially global interest rates. Also, bubbles require exuberance and leverage. The fact that the questions above are being asked so often indicates that exuberance is low and leverage likely is too.

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Presidents, Markets, and the Anxiety They Cause

In conversations regarding the markets this year, some have asked me: what do you think will happen to the stock market if the Trump Presidency runs into significant legal problems or even impeachment? My candid and apolitical response: all else being equal, stocks will rally after a period of distress, because markets hate uncertainty and while the current administration already has lots of it, the process of its downfall would create more.

If history tells us anything, it's this: an administration under fire can cause some pain in the markets, resolution will take a lot longer than most people expect, and the markets seem to like it when that resolution is found. Meanwhile, other things easily create more distress in the markets than the political scandal itself. For two useful points of reference, let's examine how the markets have previously responded to beleaguered modern presidents. 

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The Necessity of Optimism

The United States of America Certificate of Naturalization
Number: 2224130
Petition Volume: 147
Number: 15359
Description: Age: 23, Height: 5 feet, 6 inches, Color: White, Complexion: Light, Eyes: Blue, Hair: Brown, Distinguishing marks: None
Name: Charles Patrick McVeigh

In Testimony Whereof, the seal of said court is hereunto affixed on the 1st day of June, in the year of our Lord Nineteen Hundred and Twenty-Six, and of our Independence, the One Hundred and Fiftieth.
           --James L Hotchkiss - Clerk of Supreme Court, Monroe County, New York

I’m too privileged. Too privileged to have a genuine understanding of what it took for my grandfather to make the journey. A journey where memory begins as an orphaned youth, wanders without formal education toward the Irish Calvary, and ultimately through Ellis Island to the United States of America.

I’m too cloistered. Too cloistered to imagine what he must have felt when the formless took shape. Different elements coming into focus, horizon growing visible, and the crystallizing view of Liberty Island and our revered sentinel, Lady Liberty.

Despite the differences between my grandfather’s start in life and my own, I have come to understand, and embrace, his most important personality trait. Optimism. He expected the good. He believed hard work, resilience, discipline, and a commitment to deferred gratification, would ensure a brighter tomorrow. To him, a healthy sense of optimism was not only important; but indeed a necessity.

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Punching Out Your Portfolio

Over the past few weeks, the Dow hit yet another new high of 21,000, the market matched a record 12 day streak of gains and Snap Inc. (NYSE: SNAP) went public with a near $30 billion IPO despite no one over the age of 30 really understanding what it is. Consider also that we just celebrated the 8th birthday of the bull market dating back to 2009 and it's understandable that many investors are feeling like this is all too good to be true. Perhaps we are due for a retreat. Perhaps not. After all, it would have been just as easy at any time over the last 8 years to cite reasons why the market couldn't keep going up. Remember how you felt when news broke about Brexit? How calm were you as U.S. Government debt was downgraded, as oil prices plunged towards $20 a barrel or as the bull market eclipsed the 5, then 6, then 7 year mark?

Want more "evidence?" My twitter feed recently featured a sponsored ad revealing Mike Tyson as the spokesperson for a new brokerage firm touting the benefits of 400x leverage and a message of trust. Yep, that Mike Tyson who was once on top of the sports world as the youngest ever Heavy Weight Champion of the World who’s better known these days as a bankrupted convicted felon with a taste for facial tattoos and other boxer’s ears. Predictably, the humorous retweets calling his endorsement of anything even remotely related to financial services as either a sign of the apocalypse or the ultimate proof that the market had run too far were endless.

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It's Lonely at the Bottom

As the U.S. stock market ascends to new heights and hogs all the attention, these days it's easy to forget how low interest rates have fallen and perhaps more importantly, why you should actually care! While falling interest rates were great for mortgage refinancing and those who bought 30-year treasury bonds in 1987, future opportunities to refinance a 30-year mortgage below 4% won't be common and good luck reinvesting the cash the Treasury is about to wire to your account at anything close to the rate you were getting. Not surprisingly, many investors are leaving the low yielding fixed income markets and piling more of their savings into stocks. It's enough to make anyone still methodically investing in bonds feel a bit lonely.

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