Grim as the story told by the major market averages in March, the truth was even worse.
And that’s saying something, since the S&P 500 in March lost 12.5%, making it the fourth worst month of any of the past 50 years. But the actual carnage was even more devastating: More than half the 100 investment newsletters monitored by my Hulbert Ratings auditing firm lost more money last month than the S&P 500; their average loss was 15.1%.
I think these results are not a fluke, but reflect profound shifts in the investment landscape.
The reason the March results are so noteworthy is that the typical pattern is for advisers to outperform the market during declines and lag during rallies. On average across all bear markets since 1980, for example, 65% of the newsletters my firm monitors beat the S&P 500. The comparable percentage during bull markets is around 25%.
One main reason this pattern didn’t hold up in the recent bear market was that the smaller- and mid-cap issues favored by the typical investment newsletter lost a lot more than the mega-cap stocks that dominate benchmarks such as the S&P 500. This is unusual because those mega-cap stocks are among the most liquid, and in the mad rush to liquidity like what we recently experienced, one would expect those stocks to be especially hard hit.
Not this time around, however.
Consider the five mega-cap companies that, according to a recent study, accounted for an incredible 22.1% of the total wealth creation in the stock market over the three years through the end of last year: Apple (AAPL) - Get Report, Microsoft (MSFT) - Get Report, Amazon (AMZN) - Get Report, Alphabet (Google) (GOOGL) - Get Report and Facebook (FB) - Get Report. On average, these five companies lost 6.5% in March, half that of the S&P 500 as a whole. In contrast, the Russell 2000 index of smaller-cap stocks lost 21.9%, nearly double the S&P 500’s loss.
Many commentators are explaining this greater loss as a reflection of how many of those smaller companies won’t survive the economic downturn wrought by the Covid-19 pandemic. While no doubt true, that explanation glosses over the bigger story of why those companies were in such a vulnerable position to begin with.
That bigger story has to do with the increasing concentration of profits in the very largest companies. I discussed this trend in a column two months ago, you may recall, in which I reported the percentage of total corporate profits coming from the top 100 companies. In 1975 that proportion was 48.5%, and in 1995 it was only modestly higher at 52.8%. But by 2015 it had skyrocketed to 84.2%.
This means that the thousands of publicly-traded companies other than the most profitable 100 are, in essence, fighting over the crumbs that are falling off the banquet table of those 100. On balance those thousands are barely profitable, even in the best of times. It doesn’t take much of a downturn to push them out of business for good.
Many commentators have blamed the officers and directors of those barely profitable companies for gross mismanagement. They supposedly have been far too willing to go into debt to finance buybacks and other tools of financial engineering, leaving their companies in an extremely vulnerable position. But for that mismanagement, these commentators argue, those companies would be better able to weather economic storms such as the one we are now facing.
I’m not so sure. As I discussed in that earlier column, the more fundamental reason that profits are becoming concentrated in a few big companies is that the marketplace is shifting in the direction of what researchers call the “Winner Take All” economy. And the internet is the single biggest cause of that shift, as described in this seminal study on the subject.
So a focus on mismanagement misses the forest for the trees. The more fundamental story is the shift to more and more of the corporate world’s profits accruing to fewer and fewer companies.
The investment implication is that, unless we have especially compelling reasons to do so, we shouldn’t deviate from a cap-weighted index fund benchmarked to the S&P 500 or other major index. The cost is simply too great of not investing in one or more of the super-profitable companies.
Just consider those five companies mentioned above that accounted for 22.1% of the total wealth creation in the stock market over the three years through the end of last year. You could have owned every other publicly traded company besides those five, more than 4,000 in total, and yet still would have lagged a total-market index fund by 22.1%. That’s simply incredible.