Given current economic weakness, some people have asked: how is it possible that the benchmark S&P 500 index has rebounded nicely from the March lows (recovered around 50% of the drop) and is currently at similar levels to where it was in mid-2019 when things were clearly looking much better? There are (at least) two answers to this: 1. Equity prices are determined by the expected future profits of a company, but also by the interest rate at which these future cash flows are discounted back to the present time. Profits have and will be hit by Coronavirus. However, on the other hand, due to aggressive central bank action, the discount rate (comprised of a risk-free and credit spread component) has also been slashed. Mathematically, given that both the numerator (profits) and the denominator (discount rate) have fallen in tandem, it is possible that the outcome (equity valuation) remains the same. 2. The broad market indices, such as the S&P 500, do not tell the real story about the economy. Beneath the surface of the broad-market index, there are major disparities in the performance of sectors and stocks-
a. Some sectors that are seen as immune or even benefitting from the situation – e.g. healthcare and technology - are down only single-digits this year, while others, such as energy and financials, have dropped 30-45%.
b. There is significant concentration within the S&P 500: The five largest stocks in the index, Microsoft, Amazon, Apple, Google and Facebook, collectively represent a piece of the pie that is larger than any other five stocks since the late 1970s (see chart below from Bianco Research – they currently represent over 20% of the index). In fact, these five stocks have as big a weighting in the S&P 500 as the bottom 350 stocks in the index! These technology stocks have largely retained their market valuations, while the rest of the market tumbled.
c. The S&P 500 is a large-capitalization index. It represents the largest companies in the US. Even after the recent rebound, the Russell 2000 index, the small-capitalization index, representing smaller companies, is still down -29% this year, much worse than the S&P 500.
We will continue to update.