Why Beating The S&P 500 Is So Hard, And Why Even Protecting Against A 10-15% Correction Matters

|
Includes: AAPL, AMZN, BIIB, GILD, PXD, RIG, VT, XOM
by: Robert Duval

Summary

S&P 500 is a market cap weighted index, and thus is a poor representation for expected individual portfolio returns.

Great stocks like AAPL become an ever larger weight in the index, their strength sometimes masking weakness in the underlying broader universe of stocks, well preceding an actual correction.

S&P 500 is not a leading indicator of a general correction, but a follower; as money first rotates into the largest weighted stocks before finally going to cash.

By the time a general correction becomes apparent and calls to raise cash are initiated, many stocks, like now, are already down 30-40% or more from bull market highs.

Have you ever asked yourself, as a long term, diversified holder of US stocks, why your portfolio has a such a difficult time outperforming the widely used benchmark index, the S&P 500 index.

We will discuss how the S&P 500 can send a distorted message on the strength or weakness of US equity markets, and other benchmarks US investors can use to serve as advance warning indicators to raise cash and assume a more defensive posture, well before the mainstream.

For reasons partially related to this distortion, over the last year in particular the S&P 500 has become much more irrelevant to me in terms of my own trading and allocation strategy. I no longer care to make SPX target price predictions, whether a bull phase will continue or a correction will develop at a particular point in time.

I am far more focused on the not so simple exercise of attempting to price risk as applied to individual sectors of the broader market; and starting from a baseline of a neutral broad market influence, (which is reasonable I believe at today's juncture) executing on positions I deem have a sufficient risk/reward ratio.

This relatively agnostic approach to the S&P 500 - at least at this fully valued juncture - is serving me well. In other words, with analyzing a short position, I assume zero "help" from a correcting general market, Greece, China or other external events.

I currently have a focused short position on US shale oil, for example, the risk reward analysis stands on its own merits based on my view of crude oil and the outlook for US shale producers, and not based on any imminent correction.

To continue with the discussion on the S&P 500 indexes and its limitations...

It has to do with how the index is constructed, in short winning stocks are rewarded with a larger weighting in the index, poor performers ultimately degrade to a meaningless weighting (or are kicked out), in an ongoing re-weighting process that ensures the success of the index compared to the overall universe of US stocks.

Let's discuss first to illustrate this trend, a few of the of the great index winners, and then proceed to other benchmarks and sectors the individual can track to help paint a more complete picture of the health, or lack of, in US equity markets at any one time.

Apple (NASDAQ:AAPL) - 10-year chart: 2015 index weight: 3.968530

2006 index weight: Under 0.5%

AAPL Chart

AAPL data by YCharts

2 others that have been added to the S&P 500 in recent years, Amazon (NASDAQ:AMZN) (in 2005) and Gilead (NASDAQ:GILD) (in 2004). Both now with about a 1% weighting have had an undeniable positive effect on the index and their weighting goes up:

AMZN Chart

AMZN data by YCharts

GILD Chart

GILD data by YCharts

The inverse is poor performers slowly degrade in weighting until they disappear from the index. The index consistently rewards winners, making it both difficult to outperform the index, and masking broader market weakness, as these stars are not the first to correct, but the last.

The reason for this trend has to do with investor, and especially institutional behavior at the commencement of corrective activity in the broader market.

In the incipient stages of corrective activity, institutions will often not go right to cash but increase their allocation to the largest, highest quality S&P 500 stocks as a defensive measure, at the expense of a larger group of secondary, smaller, perceived weaker stocks.

This is also partially for appearance sake - funds always desire to show winners on their quarterly end statements as a marketing exercise.

Therefore, in the latter stages of a bull trend, the primary indexes look fine as money flows into an ever narrowing group of heavily index weighted stocks.

Even though a technology stock like AAPL is still considered a growth stock, it is now also considered a defensive place to maintain an investment allocation and collect the dividend during uncertain or corrective market periods.

In biotech, giants like Amgen (NASDAQ:AMGN) and Biogen (NASDAQ:BIIB) serve this purpose; in energy, this would be served by heavily weighted Exxon Mobil (NYSE:XOM). Although energy has been a lagging sector with massive breakdowns in many, many stocks, this has had a limited effect on the S&P 500 because of the defensive appeal.

Let's further illustrate by examining the completely different picture of the energy sector painted by a heavily index weighted defensive name, Exxon, a leading shale oil producer, Pioneer Resources (NYSE:PXD), and leading driller, Transocean (NYSE:RIG), over the last 5 years, paying close attention to the last year:

XOM Chart

XOM data by YCharts

PXD Chart

PXD data by YCharts

RIG Chart

RIG data by YCharts

It is exactly this behavior that explains why subsection and market breadth indicators usually break down first in a correction, then ultimately the S&P 500 as finally money flows from the leaders to cash or bonds as a greater safe haven.

Let's examine the S&P 500 index, compared the unweighted NY composite index of over 2,000 securities to illustrate the growing divergence in the picture they represent, again focused on the last year:

^SPX Chart

^SPX data by YCharts

^NYA Chart

^NYA data by YCharts

Although initially subtle, the NYA has a decline over the last year, the S&P 500 still has a solid advance, and the NYA is making lower highs and lower lows currently than the SPX.

Lastly, I still continue to give weight to the message sent by the transports. It's very interesting to continue to see persistent weakness there, in an environment that should be Goldilocks for transports - an improving economy and low oil prices:

IYT Chart

IYT data by YCharts

To conclude, I believe we live in a very interconnected world. Here is a chart of (NYSEARCA:VT) - the (still market weighted, and quite heavily influenced by S&P 500 performance) Vanguard Total World Stock ETF. Note the difference with SPX - clearly underperforming:

VT Chart

VT data by YCharts

Conclusion - the measurement of a healthy market means evaluating not only the performance of the strongest group of stocks, represented by the S&P 500, but also of the broadest group for performance, as measured through unweighted indexes, international indexes, and sectors. It is a healthier market when as many horses as possible are pulling the wagon.

Through careful study, the individual investor can glean early warning signs of corrective activity and avoid having to raise cash at an unfavourable time when the corrective activity is more obvious.

A 10-15% correction may seem irrelevant to the long-term investor, and depending on the structure of your holdings, it may be. Currently, the S&P 500 is but a few % off of its all-time highs, but many stocks are already well off their highs.

I trust I've illustrated, if and when the S&P 500 next experiences a 10-15%, multi-week correction - and we haven't had one since 2011 - the actual mark-to-market losses may exceed 30-50% on many stocks from their highs (and some are already there, particularly in the energy sector), possibly pressuring selling at an unfavorable time among overallocated investors.

It is my view that while such a correction is far from assured, and notwithstanding my comments above on the wisdom of being relatively agnostic on the S&P 500 - the current overall risk/reward environment as I have detailed in other writings, heavily favors taking a measured amount of defensive action - as opposed to any short exposure, which is a completely different discussion and a strategy I do not advocate for the vast majority of individual investors.

As a brief refresher, current external risk factors I am monitoring in particular that - may - impact US markets, include:

  1. Higher rates continuing or accelerating - not Fed tightening, but higher long bond, junk and corporate rates, all of which increase mortgage rates and impede the massive flow of share buybacks with borrowed money that have been a support to the market. Fed policy action does not substantially figure into this possibility. I do not anticipate in my modeling any Fed rate hikes in 2015.
  2. China's market "crash" developing into an economic "crash" or affecting credit markets in a disorderly manner.
  3. Greece - only if the Greek situation spreads into credit contagion in larger European countries, something not apparent so far. A subset, and more likely concern, is an acceleration of the euro currency below parity, which would accelerate already current concerns about US dollar strength and resultant exporter impact.
  4. Adverse tax changes in Europe affecting US technology - impeding the mountain of cash saved in Europe and taxed at favorable rates. There has been discussion about such changes.

Through early defensive and/or raising of cash if current divergences persist, investors will be in a better place to ride out any (possible) correction, and perhaps be able to take advantage of favorable entry points with available cash reserves.

Best wishes to all investors.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: AUTHOR IS NOT A PROFESSIONAL AND DOES NOT GIVE INDIVIDUAL ADVICE. CONSULT YOUR ADVISOR. NOT STOCK ADVICE IN ANY REGARD.