Think Beyond the S&P 500 - Now More Than Ever

Investments

Jan 6

Written By Mike Mulcahy, CFA® CPWA® CTFA

Why Not Just Invest in the S&P?

With the S&P 500 hitting all-time highs in 2021 (70 times!) and delivering 28.7% returns during the year (20th best since 1928), why not just keep investing in what’s winning? Why take on the risks of other markets when everything is so good with the S&P?

If you find yourself myopically focused on the S&P 500 and heavily influenced by recent past performance, I encourage you to read on. We continue to believe there is value in broader diversification and potentially good (better) investments elsewhere.

The S&P 500 is Not as Diversified as it Used to Be

Since the 1990’s there has been an increasing concentration of the Top 10 companies within the S&P 500 (see Vanguard chart below). Today, the Top 10 represents 29% of the total market cap of the S&P. A number that has doubled over the last 20 years. And, the S&P 500 is now more focused on technology (24%), a level that is reminiscent of the late 1990s tech bubble. This historical source of diversification just isn’t as diversified as it used to be. A pure S&P strategy is one that continues to take on more single company risk. And more risk related to technology and healthcare at the expense of other industries and sectors.

Top 10 Holdings % of Vanguard Total Stock Market Index

The US will Not Always Dominate

Sure, the US markets have done well in the past 10 years, but that isn’t always the case relative to international markets. In a previous blog (“Why Should I Invest Globally?”) we compared US investing vs. international investing. We highlighted the differences in industry/sector and market cycle benefits. We looked at historical return data which indeed shows that the geographical markets go through cycles. While the US had done well recently, the US hasn’t always done better. In fact, if you look at year-by-year returns, there is a pretty even split over the last 70+ years. So, unless you think that US-based companies are going to dominate the world forever and the rest of the world’s companies are just going to let that happen, keep a global perspective. History shows cycles and the current US dominance has been a good run.

The Gap Between Growth and Value Stocks is Growing

There are many ways to define diversification such as company level, industry, sector, geographic, company size, and even valuation diversification. What do we mean by valuation diversification? For investors, this is the classic value vs. growth spread – the gap between the most expensive companies as measured by price-to-earnings (or similar ratio) and the cheapest companies. Since 1928, “value” (cheap, low P/E stocks) outperformed expensive (growth high P/E stocks) by over 4% per year (according to this DFA analysis). It’s not every year but there are some noticeable cycles.

What makes this interesting is that we have been in a fairly long growth cycle as growth stocks have outperformed value stocks in most markets at historical levels.

A recent “no word” blog from AQR Management provides a single graphic that shows the global value/growth spread in unchartered territory. More than 4 standard deviations from the median (for your non-statistician types, this means we are in very rare territory!).

Global Value Spreads

Hypothetical AQR Industry-and-Dollar-Neutral All-Country Value Portfolio

Source: AQR. January 1, 1990 – November 30, 2021.

This AQR research is a bit technical and you need to read their footnotes (but we encourage you to review it). We want to put our simpler perspective on this phenomenon. We took a look at 10-year returns across value and growth markets in the US, international markets, and emerging markets. And we looked at the change in P/E ratios over this time. What we see is:

US large cap and small cap growth have provided the strongest returns but also remain the most highly valued. Expectations for more growth persist. Is this probable?
Growth stocks across the global market have expanded their P/Es much more than their value counterparts over the last 10 years. In fact, value had very little expansion.
US growth valuations are quite high; and US, EM, and International value remain historically reasonable.

10-Year Returns and Changes in PE Ratio

While we never know when the “momentum” will stop on the US growth market, we do know that:

Geographic diversification has provided benefits historically, and the US dominance has had a nice long run.
S&P 500 isn’t as diversified as it used to be, and investing only in S&P 500 introduces its own set of risks.
Growth’s 10+ year dominance, the historical growth vs value differential, and the historical value premiums trends suggest leaning toward value in preparation for a cycle shift.
US vs international/emerging markets valuations suggest tilting beyond our homeland into “cheaper” territories.

Design Your Portfolio Around Your Financial Needs

Every portfolio should be designed around a specific investment strategy that fits your financial needs. This blog provides general educational content and is not a specific investment recommendation. Should you seek an investment plan specific to your situation, please feel free to reach out to us.

diversificationvalue spreadvalue vs growth

Mike Mulcahy, CFA® CPWA® CTFA

With the founding of Kings Path Partners, Mike brings a diverse set of professional and personal experiences into the wealth services business. His professional roles and community experiences give him a unique and real perspective into the needs of families, entrepreneurs, and business executives. Previous roles include president of a $6B investment management firm; management consultant with McKinsey & Company; VP of corporate finance & strategy with Compaq/HP; and managing director of an entrepreneurial web-based business. He is also an active venture investor with a focus on impact investing and social enterprises.

Mike earned an MBA from the Harvard Graduate School of Business and completed an Executive Program in Portfolio Management at the University of Chicago. He graduated summa cum laude with a Bachelor of Science in Economics with a minor in Chemistry from Texas A&M University. He holds designations as a Certified Private Wealth Adviser®, Chartered Financial Analyst®, and Certified Trust and Fiduciary Advisor (CTFA). He is a member of the Investments & Wealth Institute® and the CFA Society of Houston.

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