Software Has Eaten The S&P500 - Where Should Investors Look For Loosely-Correlated Returns?

About: SPDR S&P 500 Trust ETF (SPY), Includes: QQQ
by: Cestrian Capital Research

The S&P500 returned more or less zero capital gain in the twelve months to the end of August.

In previous times, when the S&P was moribund, investors could seek greater risk and potential reward from the NASDAQ.

But - software has indeed eaten the world - and with it the S&P500.  The NASDAQ did not offer uncorrelated returns in the last twelve months.

Investors looking for returns correlated loosely to the S&P may have to look further afield.

DISCLAIMER: This article is not directed at, nor intended to be relied upon by any UK recipients. Any information or analysis in this article is not an offer to sell or buy any securities. Nothing in it is intended to be investment advice and it should not be relied upon to make investment decisions. Cestrian Capital Research Inc or its employees or the author of this article or related persons may have a position in any investments mentioned in this article. Any opinions or probabilities expressed in this report are those of the author as of the article date of publication and are subject to change without notice.

Buy & Hold The S&P500 - A Decade-Long Great Strategy

Since the financial crisis, one of the smartest moves any investor could make was simply to buy the S&P500 and hold it. Investing via the ETF SPY, the results have been stellar, as the chart below shows. If you adopted this strategy, congratulations. Low fees, little or no effort, modest volatility, highly stable underlying assets, great returns. Amazing!

Source: Ycharts, Cestrian Analysis

Conditions Appear To Have Changed

Something appears to have changed in 2019.

The market downturn during Q4 2018, widely attributed to the Federal Reserve moving in insufficiently Delphic ways, ie. by attempting to cool the economy and the market explicitly, was swift and brutal.

The S&P500 then staged a recovery very quickly indeed through the first half of 2019. But as we moved into the second half, volatility returned and by the end of August, the S&P500 had achieve in essence zero capital gain for a year.

Source:, Cestrian Analysis

There are many reasons posited for this, as we have commented elsewhere. You might read the chart as a tussle between the US Administration, the Chinese government, and the Federal Reserve, to determine who has the whip hand. The market moves this way and that in a struggle to keep up.

Now, in times gone by, the S&P500 was viewed as a home for stalwart but stodgy companies, those whose growth tracks US GDP growth fairly closely. If that was the case, one could explain the volatile and slowing returns of the S&P by looking at the perceived risk to the US economy from tariffs and the other factors indicated above.

That being the case, investors frequently chose to look elsewhere to add a little uncorrelated risk/reward to their core S&P500 holding.

Traditionally the first port of call for this was the NASDAQ index, presented below as the ETF QQQ. You can see why.

Source:, Cestrian Analysis

But again - things seem to have changed. The NASDAQ has performed no better in the last twelve months than has the SPY.

Source:, Cestrian Analysis

The reason, it turns out, is simple. QQQ and SPY have a very similar set of their larger holdings.

Here's SPY:

Source: SeekingAlpha

And here's QQQ:

Source: SeekingAlpha

Both these leading ETFs include MSFT, AAPL, AMZN, FB, GOOG, GOOGL. Just a few years back that would have been remarkable. It tells you how much the mega-cap tech sector has matured and become part of the plumbing.

You may recall back in 2011 that the creator of Netscape (for youngsters: the first commercially available web browser) Marc Andreesen, by then a highly successful venture capitalist, opined that "software is eating the world". He was right, as it turned out. And software's low-cost nature has delivered high margins and cashflows to its leading protagonists - who have found a welcoming global market for their products and services - which has in turn made those software companies leviathan.

And you can see the collorary of that which is - the S&P ETF looks remarkably similar to QQQ at the top end of its holdings. So in the last year there was little appeal in QQQ if you are trying to find a place to escape the S&P500.

So - What To Do?

Most investors are of the view that you always want some exposure to the S&P500. It means you're investing in the future growth of the US economy, which is a better bet than most other economies, most of the time. And it means you are exposed to large companies which are typically better set to ride out any bumps in the road, be they large or small.

We aren't going to try to dissuade you of that notion. If it's good enough for Warren Buffet, it's good enough for us.

But if you want to look further afield for risk and potential return that is correlated only loosely to the S&P, we think you have two basic choices. Either - dive into individual stock-picking (or niche ETF-picking) where, regardless of industry, you believe the stock is undervalued vs. its prospects; or choose industries which are in their early stages of growth and are likely to outperform the S&P over the long term - by which we mean say three to five years. After all, before software ate the world, that's what software offered - companies growing faster than the market because the industry was young.


There are plentiful pockets within tech that are well placed to grow much faster than the US economy at large. Our own view is that if you want to find these outperforming subsectors in tech, look for high growth deflationary companies. That is, companies whose products or services reduce the price at which their existing market can be served. The poster child of deflation in the last two decades is Amazon. Cheaper, faster than brick and mortar - shareholders willing to tolerate much lower margins than they ever would from say Wal-Mart (in exchange for higher growth of course) - ergo rapid revenue growth and with it, share price appreciation. That game for AMZN is over for the moment - it's in transition to being valued on earnings just like Wal-Mart (WMT) - and until it gets there we think the share price will be directionless. No, if you want to invest in deflationary tech, look at younger subsectors. Databases - MongoDB (MDB) - deflating Oracle; communications software - Twilio (TWLO) - deflating carriers; adtech - The Trade Desk (TTD) - deflating Facebook (FB) and Google (GOOG); those sorts of things. The issue right now with such stocks is valuation. If it's cloud-based and growing quickly, you'll be paying well north of 10x forward revenues, maybe north of 20x forward. And with the world in its current state of flux you need to be confident that those multiples are going to hold up. (We'll be dealing with this in a future note).


This isn't our area of specialism but it is certainly an industry riding a wave of demand following deregulation. As outsiders we're sceptical of the barriers to entry and sustainability of margins - but again it's not our area so this could well be a good industry to back. We suspect there is a wealth of opinion here on SA to help inform you. It amused us recently to learn that Scott's Miracle-Gro Corp (SMG) has profited handsomely from this deregulation and that its stock price is up by 50% in the last twelve months. So perhaps there are solid ways to play the cannabis trend. There are multiple ETFs in the sector of course.


Now this IS our area but we aren't going to use this note to pitch the industry to you. You can read our thoughts on the space sector here. What we will say is that the industry is at the beginning of what we believe is a multi-decade secular growth run and, fuelled by national security spending on the military side, and with internal cost reduction driving demand growth on the commercial side, we believe it's here to stay for the duration. The national security aspect we believe offers the opportunity for growth even if and when the wider economy slows.


From where we sit, the market is jumpy. With the tensions we outline above it is both directionless and volatile. We see upward pressure towards the 2020 election, downward pressure from the China crisis, and volatility from the market's attempts to pressure the Fed towards lower or even negative rates. A heady mix indeed. Now, this might all work out just great and it might be that owning the S&P or indeed the Nasdaq is all you need to do for the next few years. If so - that's good news for all of us because it means we're in a benign environment. But our hunch says that that won't be enough. That investors need to look further afield and get more specialized in order to optimize their risk/reward balance.

Cestrian Capital Research, Inc - 9 September 2019.

Disclosure: I am/we are long MSFT, TWLO, MDB. 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.