Question:  

I’m more confused this year than ever about financial markets and economic data. Can you help?

Answer: 

You’re not alone in being perplexed trying to decipher muddled signals from financial markets. Financial markets are not the economy, and vice versa making it all the more confusing as we digest data. In addition, investors own interest in companies, not countries. Financial market activity is reported in relationship to indexes, and economic data covers employment, inflation numbers, interest rates, job participation and other leading economic indicators. 

Investors have focused on benchmarks or indices over the years and have been taught by financial networks, newsletters, or investment professionals, that measuring investment results against an index is appropriate. While benchmarks can serve a valuable purpose it is imperative that investors understand what a benchmark is, and more importantly, what it is not. Measuring to your goals and risk appetite may be more appropriate. 

The most widely used indices to measure performance of a stock portfolio are those produced by Standard & Poor’s (S&P) and Russell. Although the Dow Jones is quoted on the evening news, it has little bearing on the broad markets since the Dow Jones Industrial index is comprised of only thirty stocks. In contrast, The Standard & Poor’s 500 (S&P 500) index is a widely accepted benchmark used to compare equity performance in mainstream financial circles.

The S&P 500 is an unmanaged index of 500 widely held stocks that is generally considered representative of the U.S. stock market. The Dow Jones Industrial Average (DJIA) commonly known as “The Dow” is an index representing 30 stocks of companies maintained and reviewed by the editors of the Wall Street Journal. The Russell 2000 Index measures the performance of the 2,000 smallest companies in the Russell 3000 Index, which represents approximately 8% of the total market capitalization of the Russell 3000 Index.

The S&P 500 index was originally created in 1923 and known as Standard Statistics Company when only 233 companies were represented. The S&P 500 in its present form was introduced in 1957, expanding to include five hundred of the largest companies in the U.S. consisting of eleven sectors: Technology, Health Care, Financials, Real Estate, Energy, Materials, Consumer Discretionary, Industrials, Utilities, Consumer Staples, and Communications. During May 2023, eight of the eleven sectors were down significantly with the large-cap technology names pulling the index higher. 

Divergence

The three sectors that were up are information technology, communication services, and consumer discretionary names. Narrow tech focused leadership remains as a key theme driving the equity markets. Optimism on artificial intelligence fueled a powerful rally in tech stocks. The MAGMAN leaders’ names are Microsoft, Apple, Google (also known as Alphabet), Meta (formerly Facebook), Amazon, and NVIDIA. 

Of the S&P 500, there are five names that are responsible for the vast majority of gains and those companies are NVIDIA, Amazon, Apple, Microsoft, and Alphabet (formerly Google). These five companies account for 24.7% share of the S&P 500 market capitalization. It’s interesting to note that the market cap of Apple is larger than the entire  2000 Index.

Market cap is calculated by multiplying the number of shares outstanding of a company by share price for a total valuation. These five companies reflect close to one-fifth of the entire S&P 500 index, which is significant. In the late 1990’s, the so-called “Four Horsemen” of markets were Intel, Cisco, Microsoft, and Oracle. During the Seventies, the “Nifty Fifty” led the market. 

At the moment, breadth is weak, and leadership is narrow with the large tech companies overshadowing underperformance in the majority of companies. The economy and consumers remain resilient in the midst of falling inflation, the beginning of the end of the Fed’s interest rate hikes. 

Leadership has been narrow, indicating that the market may be out of step. Small and mid-sized companies may begin to see movement as investors recalibrate in response to optimism and normalization trends. Higher quality names with lower volatility may benefit most as the overall market catches up to the high-flying tech names. 

When markets consolidate, it’s expected that companies with stable earnings growth, high-free cash flow, low debt, and profits, have potential to participate. It’s important to avoid the urge to chase specific names higher. Remaining diversified with quality names may help mitigate volatility. It can be tempting to let Artificial Intelligence enthusiasm pull you away from investment fundamentals, valuations, and a custom planning process. Diverging patterns will emerge making diversification a key component of financial planning. Stay focused and plan accordingly.