Please don’t panic about the skew

Fears that a small number of stocks are driving the rally in the US abound, but this is view is erroneous. In all rallies, a small number of names drives the move higher.

Trader
Source: Bloomberg

A new ‘concern’ for some investors has been the skew of returns in an index. According to some commentators, including fund managers who should know better, the small number of stocks providing the majority of the return for the overall index is a worrying sign, and could lead to a renewed sell-off.
This is, to put it nicely, nonsense. It is merely the latest scare story in a market dominated by such ‘reasons to worry’. Before this reason came along, it was ‘quantitative easing (QE) is driving stock markets higher’ (it isn’t), or ‘buybacks are pushing equities higher’ (they aren’t, the majority of the appreciation in the S&P 500 comes from earnings, around 90%), and so on.

For most indices, and for most rallies, skewed returns are the norm, not the exception. An index is an average of all the stocks in that basket. Some will do better, and some worse. If you survey drivers, most people claim that their driving is above average. But that is statistically impossible. By definition, most stocks must be below average.

The chart below shows the skew for the S&P 500 over the past 20 years:

The chart shows that the median return for an S&P 500 stock is 50%. The average is 227%. Most stocks underperform the average.

This time around it is the big tech stocks like Amazon and Apple. Next time it might be an entirely different sector, but the same skew will persist.

Momentum is a very powerful force, and trends go on for much longer than can ever seem possible. Stocks can also remain fundamentally overvalued on a variety of metrics before a sell-off occurs to reset the market.
Abandoning the strong performers to pick up some underperformers is usually a bad idea. In the short run, the market is a voting machine, and the popular stocks can be driven higher for a long time. Diversification is important, but the need to diversify is why most active managers underperform the index.

The information on this page does not contain a record of our trading prices, or an offer of, or solicitation for, a transaction in any financial instrument. IG Bank S.A. accepts no responsibility for any use that may be made of these comments and for any consequences that result. No representation or warranty is given as to the accuracy or completeness of this information. Consequently any person acting on it does so entirely at their own risk. Any research provided does not have regard to the specific investment objectives, financial situation and needs of any specific person who may receive it and as such is considered to be a marketing communication.