Famous investor Warren Buffett is famous for (among other things) winning a bet that money parked in an S&P 500 (SNPINDEX: ^GSPC) index fund would outperform professional money managers over 10 years. It’s not easy to consistently beat a collection of the world’s largest and most influential companies.
But can it be done over one year? I think it can, and I’m going to show you the crazy blueprint to do just that in 2022. Here is why and how you could beat the S&P 500 this year.
The anatomy of the S&P 500
The S&P 500 is an index constructed by a committee and owned by S&P Dow Jones Indices, a joint venture majority-owned by S&P Global, which specializes in analytics and information for the financial markets. The index includes 500 companies generally considered the most prominent in the United States and traditionally viewed as the best overall benchmark for the U.S. stock market.
But these 500 companies aren’t represented equally. The top 10 highest-weighted members make up roughly 30% of the entire index. These companies include:
Alphabet (Class A shares)
Alphabet (Class C shares)
Berkshire Hathaway (Class B shares)
That leaves the other 70% for the other 490 stocks. A broad market movement such as a bull market can move the index, but these larger members can also influence the index if their price movement is dramatic enough.
Many top members have stretched valuations
A similar situation could be playing out in the index right now — the S&P 500 is only 3% away from its all-time high. But the broader stock market doesn’t seem relatively healthy if you look closer.
For example, let’s look at the 500 stocks in the index. Only 357 of them are above their 200-day moving average, which indicates a stock’s price momentum by averaging its closing price over the past 200 market sessions. In other words, more than one in four S&P 500 components are struggling right now.
If we look at the Nasdaq, a fellow index that concentrates on technology stocks, just over one in four stocks are above their 200-day moving average. Put another way, more than three-quarters of the Nasdaq’s stocks have negative price momentum!
It seems that tech companies are broadly having a tough time right now, which could be explained by the ongoing high inflation threatening to cause increased interest rates. Higher interest rates can cause stock valuations to decrease.
Some mega-cap stocks that sit at the top of the S&P 500 have remained popular, which has resulted in continued price appreciation and high valuations.
Now, the S&P 500 is at a price-to-earnings (PE) ratio of 24.5, roughly 50% higher than its historical average of 16. Nobody knows what will happen in the future, but it seems that the weakness of lower-weighted stocks in the major indexes could indicate the actual condition of the markets. If the mega-caps finally begin to correct, it could accelerate the decline of the S&P 500.
Going against the grain for gains
This scenario is an opportunity to outperform the market. Human nature makes it feel “safe” to go buy the stocks that have already been going higher, but the real opportunity might be in the beaten-down stocks, those that have lost 50% to 80% over the past year.
It doesn’t mean chasing low-quality stocks that are overly speculative or businesses losing tons of money. But the overall sentiment in the growth universe has brought most stocks down; quality names trading at expensive valuations have become reasonable or even cheap in some instances.
If growth stocks begin recovering this year, we could see the opposite of 2021 occur, when the S&P marched higher while many growth stocks floundered.
Understand the risks
There’s a large gap between the largest stocks in the indexes and the smaller ones underneath. I think there is a good chance that this gap will close, but nobody knows for sure when that will happen.
The price movement that happened throughout most of 2021 may continue through 2022. Perhaps a significant economic event will occur that is unforeseen and changes everything.
The point is that you can’t know for sure; you can only look at facts to get a sense of what’s happening around you. The best way to position your investments for success is to identify high-quality stocks whether small-, mid-, or large-cap, take a long-term approach with your holdings, and manage your risk appetite. If you do that, you’re bound to have success in 2022 and beyond.
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Suzanne Frey, an executive at Alphabet, is a member of The Motley Fool’s board of directors. Teresa Kersten, an employee of LinkedIn, a Microsoft subsidiary, is a member of The Motley Fool’s board of directors. Randi Zuckerberg, a former director of market development and spokeswoman for Facebook and sister to Meta Platforms CEO Mark Zuckerberg, is a member of The Motley Fool’s board of directors. John Mackey, CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool’s board of directors. Justin Pope has no position in any of the stocks mentioned. The Motley Fool owns and recommends Alphabet (A shares), Alphabet (C shares), Amazon, Apple, Berkshire Hathaway (B shares), Meta Platforms, Inc., Microsoft, Nvidia, S&P Global, and Tesla. The Motley Fool recommends UnitedHealth Group and recommends the following options: long January 2022 $1,920 calls on Amazon, long January 2023 $200 calls on Berkshire Hathaway (B shares), long March 2023 $120 calls on Apple, short January 2022 $1,940 calls on Amazon, short January 2023 $200 puts on Berkshire Hathaway (B shares), short January 2023 $265 calls on Berkshire Hathaway (B shares), and short March 2023 $130 calls on Apple. The Motley Fool has a disclosure policy.