Stealth Bull Market Arises as Last Year's Highfliers Tumble

Put all of the stocks in the S&P 500 into a fishbowl, close your eyes and pick one. Chances are it will have outperformed the S&P over the past year.

Of the 500 stocks in the index, 378 have a better return than the S&P's 20% decline. Even more telling, 286 have actually eked out a positive return. Finally, if you had bought all the stocks now in the S&P a year ago, giving them an equal weight rather than weighting them by market cap as the index does, you'd have a 7% return. Though everyone has lately been remarking on stocks' ursine tendencies, it appears that there is something of a stealth bull market going on.

A little more than a year ago it was quite the opposite -- the indices were romping higher, but the average stock wasn't in such good shape. Investors were flocking to the fastest growing companies with the biggest market capitalizations, and just about everything else was languishing. "The focus narrowed to only the most successful companies, the companies where the stories were the easiest to understand," explains John Bollinger, president of Bollinger Capital Management. "It was a quest for simplicity in an environment that was confounding to many."

The Equal-Weighted S&P 500 Rises

Source: Baseline

It also had something to do with a quest for outperformance in an environment in which that had become difficult. For several years, the bulk of mutual funds had been lagging the benchmark S&P index, and this appears to have led to an increase of closet indexing -- making a fund's portfolio more or less mimic the makeup of the S&P. This, in itself, can lead to a narrower market: The most money goes into the largest-cap stocks, which sends them higher, which increases their market capitalization. This effect was amplified in many technology stocks whose float -- the number of shares actively trading -- was relatively small. At the end of 1994, the top-10 stocks in the S&P made up 17.8% of the index's total capitalization. By the end of 1999, the top 10 made up 25.5%.

As the S&P became more top heavy, so did most mutual funds. At the end of last March the top-25 holdings at Fidelity's (FMAGX Quote - Cramer on FMAGX - Stock Picks)Magellan, the nation's largest fund, made up 46.8% of its $109 billion portfolio. Contrast that to September 1996, when the top-25 holdings accounted for only 25% of the Magellan portfolio, according to Morningstar.

Part of this narrowing was merely a function of a narrower market -- the few stocks that outperformed ended up getting a bigger piece of a fund's portfolios, even if the fund manager was striving for diversification. On March 10 last year, the day the Nasdaq peaked, Hugh Johnson, First Albany's chief investment officer, told TheStreet.com, "I cut [my position in] Oracle(ORCL Quote - Cramer on ORCL - Stock Picks) in late December. And I cut it again yesterday, because it got to 11% of my portfolio. I cut it back to 8%, but it'll soon be back at 11%. It's great. It's like hair -- it keeps growing."

Remember the Titanic

But another part of the problem was that diversification had burned so many managers, and in the world of mutual funds the fear of underperforming the S&P 500 is far greater than the fear of losing money outright. Moreover, it appears that many funds' strategy for beating the index was to get even more top heavy than the index was, a bet that the trend toward an increasingly narrow market would continue. This left them incredibly wrong-footed when the trend toward a narrow market reversed itself.

"Yesterday's darlings have one by one fallen out of favor and shown they're not resistant to general economic trends," says J.P. Morgan Chase strategist Tom Van Leuven. "The risk of the overconcentrated portfolio has come into focus."

But it does not appear to have been fully unwound. At the end of last year, the top-10 companies made up 23.5% of the index's total value, compared to a 20-year average of around 20%. Magellan, meanwhile, had 25.6% of its portfolio lumped into its top-10 holdings. It's difficult to turn around a supertanker.

Narrow Road to the Inferior? Top 10 Stocks in the S&P as a Percentage of Total Capitalization

Source: Standard & Poor's

"These really big funds are going to reflect the broad market trends because it's their only hope of outperforming," says Bollinger. "That means they're going to be upside down at turning points."

Lately the way to outperform has been to be less concentrated than the S&P -- as funds like (AGTHX Quote - Cramer on AGTHX - Stock Picks)Growth Fund America, which had only 20% of it's portfolio in its top-10 holdings at the end of 2000 and returned 7.5% on the year, have shown. As more fund managers and other investors cotton to the trend toward a broader market, it would make sense for the old leaders to underperform. Meanwhile, the time in the sun for all those stocks that languished in their bigger brethren's shadows may have only begun.