The Blueprint
The FAAMG Effect
The Market is Missing Breadth
Many of the conversations in the media about the stock market revolve around Apple, Amazon, Google, Microsoft and Facebook. It makes sense that these stocks are a common point of discussion; they are very widely owned, have performed exceptionally well, and even have their own acronym — the “FAAMG” stocks. With valuations rising to extraordinarily high levels many market analysts have focused on explaining why the FAAMG stocks are much better companies than the top tech names during the “tech bubble,” where valuations reached similar levels. These companies are showing that they are resilient, especially when it comes to recent performance despite the economic pressures created by COVID-19. Despite this strength, there are some risks that this outsized performance brings about that investors may not realize.
What is a Market Cap Weighted Index?
A market cap weighted index is a stock market index where the stocks are weighted according to their size as measured by their total market capitalization. This means that as large companies outperform smaller ones their weight in the index grows. This effect can be seen today where the 5 FAAMG stocks now make up 18% of the S&P 500 index — a market cap weighted index of 500 stocks.1 There has not been such a concentration in the top names since the “tech bubble” of 2000/2001.
FAAMG Stocks Make Up the Majority of the Market’s Return
Source: Source: Ycharts 1/1/2020-9/3/2020
FAAMG Index is defined as an equal weighted index of what are known as the FAAMG stocks (Facebook, Amazon, Apple, Microsoft, Google). Past performance is not indicative of future returns.
The chart above illustrates just how much disparity there has been between the big winners and the rest of the index. According to Barron’s, “market breadth is often used to assess the overall health of the stock market and forecast its future direction.” Historically, the greater number of stocks participating in the market’s positive movements has been an indication of overall economic strength. When the market’s gains are led by a small number of stocks, it can create concentration and diversification risk. Recent performance has certainly been led by a smaller number of names. This represents “narrow breadth” versus the healthier “wide breadth” observed when most stocks are doing well.
We are in an extremely challenging economic environment. The U.S. economy is facing the impact of a pandemic, bringing about massive unemployment, with stores and businesses closing in record numbers. While the market has been digesting these challenges, these companies have undeniably benefitted, while other companies have been unfortunately harmed. Although we appreciate the value creation these stocks represent, we also feel there needs to be a broadening of participation in this rally in order to create a healthier balance in the markets.
With so few stocks making up the market’s return, and with economic pressures mounting, investors that own market cap weighted index funds are at greater risk than they may realize. As these FAAMG stocks become a larger part of the index, the disparity in returns creates a concentration risk is created that people should be aware of when evaluating their investments.
Blue Square Wealth
At Blue Square rather than trying to predict the future, we aim to prepare for it, regardless of its direction. Using our proprietary technology and rules-based approach to investing, our decisions are not swayed by predictions or emotions.
Our investment strategy has a risk management focus that aims to position portfolios defensively during significant market declines. By systematically raising cash during these periods and then investing it when markets are more accommodating, we aim to create a less volatile investment experience, and ultimately deliver better risk-adjusted returns over full market cycles.
1) Source: Slickcharts.com as of 9/4/2020
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