There’s not a day that goes by when I don’t hear someone talking about how this market is being led, or held up, by only a handful of stocks. Normally I wouldn’t care, but the inference is usually followed by some sort of doomsday prediction. We all know that bear markets are a natural part of the investment cycle. They aren’t fun in the midst, but from time to time they are necessary for a variety of reasons.
One can continue to predict market crashes, and eventually they will be right. But this does no good for anyone. The S&P 500 was trading around 1,000 when the end of the world crash callers (due to Fed policy, Europe disaster, etc.) were out in full force. The S&P 500 is now trading at almost 3,000. Meaning a 70% crash would be needed, just to get back to those levels. You see, this is no way to invest successfully. Rather, this leads the novice investor to make bad decisions. So, I’m going to do my best to break down, and then debunk this “lack of participation” argument.
Let’s begin by understanding how the S&P 500 index works. It’s a “market cap” weighted index. So, the companies with the largest market cap are the ones that are weighted the highest in the index. Market cap is computed by multiplying shares outstanding by the price per share. As a companies stock price increases, it’s weight in the S&P 500 will also increase. Therefore the index is dynamic by nature.
So there is a “smidge” of truth in this argument. Yes, the companies with the highest market cap will account for a higher percentage of the index’s returns. This has always been the case, and will always be the case in the future, as long as the index remains market cap weighted.
Today we find the largest companies in the S&P 500 are mostly tech companies. But that has changed numerous times in the past. And will continue in the future. Below is a list of the 10 largest companies every five years since 1980.
