Every investor should be reading market news and paying attention to it as it relates to individual stocks. They also want to make sure they're aware of important market themes that might be lurking beyond the headlines.
Along these lines, there are four charts that tell important stories for investors and provide hard data, rather than just speculation. What they reveal could be mind-blowing to some investors, perhaps even you. Keep this information in mind as you manage your portfolio.
1. There is a lot of capital concentration at the top
The market has always been dominated by a small number of stocks, but the concentration is reaching historically unprecedented levels.
The chart above illustrates that the 10 largest stocks make up a much larger portion of the total markets capitalization than any time in the past two decades. The 10 biggest stocks now make up nearly 30% of total market value. The five largest companies in the S&P 500 — Microsoft, Apple, Alphabet, Amazon, and Tesla — are even more disproportionately represented and make up more than 20% of overall capitalization.
This concentration changes the meaning of major market index performance, and it is having a fundamental impact on index funds. The “market” is much more skewed toward massive tech and software stocks, so the headlines are less representative of all the stocks that comprise the S&P 500, Nasdaq, or Dow Jones Industrial Average. There are hundreds of major companies from different industries that are very likely not performing in line with the indexes.
Relative to prior years, the total-market returns are exposed to higher-growth businesses, which could increase potential returns. It also creates new forms of risk. These stocks have higher valuation ratios and lower dividend yields than the market leaders in past periods, so it's fair to expect more volatility. That could drive bigger losses in bear markets.
Ultimately, index investors aren't getting the same level of diversification that has traditionally been a cornerstone of passive investment strategies. More than ever before, it's important to really understand the exposure in your investment portfolio.
2. The market is outpacing GDP by a lot
Stock market returns exploded beyond overall U.S. economic growth, and the gap has grown especially wide since the 2007-09 Great Recession.
The above chart displays the cumulative percentage growth of the S&P 500 and monthly GDP in the U.S. over the past 30 years. There are a few things fueling this discrepancy. Most of the largest companies are multinational, so they've captured economic growth outside of the U.S. in places like China, South Asia, and Southeast Asia.
The ongoing rise of software also contributes to this trend. Mega-cap tech businesses are expanding much more quickly than the economy in general, whereas things like basic materials and consumer staples are much more anchored to GDP.
3. IPO volume spiked in 2021
The number of initial public offerings (IPOs) is elevated.
Some of this can be explained as pent-up demand after the first half of 2020 was disrupted, but there's more going on here. Last year's 480 IPOs was the most public company launches in a year since 1999 when 476 companies went public. In 2021, we've already had 951, nearly doubling 2020's elevated total — and the year is not yet over.
There are more “unicorns” being built these days due to the rising influence of venture capital and start-ups. Those companies are often created for the purpose of a big exit in the form of an IPO. Stock market investors are also more comfortable with high-growth companies that don't expect to achieve profitability any time soon. That means that start-ups can successfully go public sooner. The explosion of SPACs has also drastically inflated the number of IPOs over the past two years, though this effect might be dissipating.
Companies also have extra incentive to go public in today's market. High valuations result in higher payoffs for early investors, and they produce more cash to fuel ongoing growth. Speculation about changes to capital gains taxation may have also motivated private investors to cash out before tax rates rise. It's anyone's guess where the market goes from here, but we can conclude that lots of savvy financial minds are cashing in because they like the valuations in today's stock market.
4. Volatility concerns could use some perspective
It's been a wild last few months in the stock market. Investors are simultaneously digesting strange employment news, pandemic uncertainty, threats of high inflation, corporate earnings, and imminent monetary tightening from the Fed. That's created more volatility, which is measured by the CBOE Volatility Index (VIX).
So where do we actually stand today? A high VIX indicates jumpy investors who are quick to sell, which is a necessary condition for a market correction or crash. A low VIX suggests a more optimistic environment where stocks can slowly and steadily rise.
Things have settled down since last year, even in comparison to the rocket ship recovery that started in Q2 2020. Still, investors are on edge compared to most of the pre-pandemic decade, and volatility is currently above the year-to-date lows. The sky isn't falling, so don't let irrational fear influence your investment decisions. However, don't get shocked if we take some lumps over the next few months. Make sure your allocation is set up to achieve growth while managing volatility, and stick with your plan.
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