Aristocracy In The S&P 500

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Includes: DIA, QQQ, SPY
by: Neuberger Berman

What narrow stock leadership means and whether we may be in an equity market bubble.

Market followers may have noticed a theme in stories about equities lately, with headlines like "Only Six Stocks Responsible for Total Returns" and "Four Stocks Have Driven the NASDAQ." Some investors worry that narrow leadership is an early sign of a stock market bubble, as it has at certain times in the past. For others, a period of narrow leadership seeds a concern that not holding particular names may cause them to miss out on performance.

Below, we take a closer look at annual S&P 500 returns over the last 20 years and compare periods of narrow market leadership. While today's market leadership may be tighter than average, an evaluation of multiple factors may suggest we are not experiencing a market bubble, while lower return dispersion overall could help explain the challenges facing active managers today.

1. Narrow Leadership Is Potentially Less Meaningful When Market Returns Are Low

The narrow stock leadership story is an easy one to tell during periods when return levels are low. If the total return for the S&P 500 is 3%, for example, it can be easy to find a few stocks that together account for that total amount. During periods when market returns are higher, however, finding a few names that contribute such a high percentage of index returns becomes more challenging.

Let's examine contributions of the top 10 stocks to the S&P 500's annual returns over the last 20 years during positive return years. In years when the total market return has been low (0%-5%), the percentage of returns coming from the 10 best-performing stocks is extreme. In 2011, for example, when the S&P 500 returned just over 1%, the top 10 stocks were responsible for over 300% of the total returns. For 2015 returns through the end of October, the S&P 500 was up 2.7%, and the top 10 names accounted for 112% of market returns.

Once the market is out of this very low return range, we see a more typical pattern in which the 10 best stocks have accounted for 15%-35% of total market returns. In these markets, we can point to two periods of unusual narrow leadership: In 1998, the S&P 500 returned 29% and the top 10 stocks accounted for 40% of returns. And in 1999, the S&P 500 returned 21%, and the top 10 stocks contributed 61% of returns. Today, we know with the benefit of hindsight that, in 1998 and 1999, the Tech Bubble was forming, with a small number of technology stocks outperforming the overall market by a wide margin.

What is Narrow Leadership?

When people talk about narrow leadership, they usually mean that a few stocks are contributing to returns in the broader market. Sometimes the outperformance of the few stocks is small, but sometimes it can be quite a gap. In extreme cases, when the outperformance is large and attributed to just a few names or a single sector, it can even indicate that a bubble is forming or that some other imbalance is driving the market.

Contribution of the Top 10 Stocks

Source: FactSet. Data reflects total returns for the S&P 500 for each calendar year, except 2015 year to date, which is through October 30, 2015. Indexes are unmanaged and are not available for direct investment. Investing entails risks, including possible loss of principal. Past performance is no guarantee of future results.

2. Today's Market Does Not Appear to Resemble a True Bubble

Another way of gauging market breadth is to look at how many stocks outperform the index during a calendar year. Doing so yields two pieces of information: First, how much is the index being driven by a small number of names versus broader performance trends? And second, how might this impact active managers' ability to outperform the benchmark in such an environment?

As you might expect, the average number of stocks outperforming the index hovers somewhere around 50% - about half of the stocks outperform, and about half underperform. Looking at the market this way reveals which periods deviate from the usual pattern and, again, the Tech Bubble stands out. From 1996-1999, only 27%-40% of stocks outperformed the index, a much lower number than is typical - the S&P 500 during those years was driven up by a distinctly narrow group of high-performing names.

In 2000-2002, a considerably higher percentage of stocks outperformed the index, peaking at 67% in 2001. In contrast to 1996-1999, these were years of overall market losses; in this case, a small group of stocks were responsible for dragging the index down. Previously, during the formation of the Tech Bubble, a select group of high-returning companies had driven returns; when the bubble burst, a select group of plummeting names drove losses.

The Tech Bubble was an atypical market period. More often, the S&P 500 has been driven by broader performance trends, and the number of stocks outperforming the index has hovered around 50%. As for 2015 (year to date through October), the trend is a little below average, with only 45% of the 500-odd stocks in the index outperforming. But it is not the extreme case we observed in other market environments. In our view, given that this indicator has tended to be mean-reverting to around 50%, we believe that market breadth could pick up in the near future.

Bubble Bursters: During A Tech Bubble, A Few Stocks Led The Way Up - And Down

Source: FactSet. Indexes are unmanaged and are not available for direct investment. Investing entails risks, including possible loss of principal. Past performance is no guarantee of future results.

3. Wider Return Dispersion May Favor Active Managers

A final way we can examine narrow leadership is to ask how widely dispersed stock returns are within the index each year. We can look, for example, at the magnitude of the range between the single best- and worst-performing stocks for each calendar year. In some years, there is a tight range between the top and bottom performers; in other years, the gap is wider.

Mitigated Magnitude: Current Market Shows Relatively Tight Range Between Top and Bottom Performers

Source: FactSet. Indexes are unmanaged and are not available for direct investment. Investing entails risks, including possible loss of principal. Past performance is no guarantee of future results.

Of course, this only tells us about the best and worst performers in a given year; perhaps these are outliers that misrepresent the index. For a more technical, but also a more nuanced picture, we can examine the dispersion of returns for all of the stocks within the index for each calendar year, calculated using standard deviation. This gives us the performance range for a bigger set of stocks. In years when the standard deviation is lower, there is a tighter band of returns among stocks in the index. Indeed, in recent years, the band of returns has been tight, with most stocks in the same, narrower performance range. This suggests that it may be more difficult for stock pickers to outperform the index in a calendar year if their selections don't significantly outperform.

An Active Dilemma: Periods of Lower Return Dispersion Can Make Stock Picking a Challenge

Source: FactSet. Indexes are unmanaged and are not available for direct investment. Investing entails risks, including possible loss of principal. Past performance is no guarantee of future results.

Today's Markets: Not Extreme, but Slightly Narrower than Average

Taken together, these measures paint a general picture of the current market environment. Whether we measure market breadth using the contribution from the top returning stocks, the range of stock returns or dispersion between stock returns in the index, it's clear that market breadth within the S&P 500 has been narrower this year than the historical average. Consequently, we believe the environment continues to be a challenging one for stock picking.

Fortunately, our analysis of the markets does not suggest that we are in an extreme environment like the Tech Bubble with large imbalances driving returns. As such, we believe the market structure appears healthy and that returns may be driven by fundamentals. Over the longer term, we believe that market breadth statistics are typically mean-reverting and could broaden in the near future.

This material is provided for informational purposes only. Nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. The views expressed herein are generally those of Neuberger Berman's Investment Strategy Group (ISG), which analyzes market and economic indicators to develop asset allocation strategies. ISG consists of investment professionals who consult regularly with portfolio managers and investment officers across the firm. This material may include estimates, outlooks, projections and other "forward-looking statements." Due to a variety of factors, actual events may differ significantly from those presented. Any views or opinions expressed may not reflect those of the firm as a whole. Investing entails risks, including possible loss of principal. Past performance is no guarantee of future results.

Any views or opinions expressed may not reflect those of the firm as a whole. Third-party economic or market estimates discussed herein may or may not be realized and no opinion or representation is being given regarding such estimates. Certain products and services may not be available in all jurisdictions or to all client types. Indexes are unmanaged and are not available for direct investment. Unless otherwise indicated, returns shown reflect reinvestment of any dividends and distributions.

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