Investment Insights - An Index Gut Check

The S&P 500 Index is one of the most widely known stock market indexes.?It tracks the performance of 500 large U.S. companies.?Its performance and valuation are frequently quoted as representative of “the market” when referring to stocks.?Its statistical characteristics influence investment and financial planning decisions.?And the trend towards indexing as an investment strategy has meant increasing amounts of money into index-tracking investment vehicles in the pursuit of low-cost, passive rather than active investment returns.?But the S&P 500 has some quirks that have become increasingly pronounced and persistent over time.?One of these is the nature of its index methodology and its resulting top-heavy nature.?

The S&P 500 is a market capitalization weighted index, meaning larger companies exert a stronger influence over the index’s performance and characteristics.?If you can recall back to the late 1990s-era tech bubble, you may remember the beginning of these discussions.?The S&P 500 peak back in that era occurred on September 1, 2000 at an S&P 500 Index level of 1,520.77.2?I was around back then as an analyst researching health care companies.?We were just beginning to understand the human genome and biotech was a very new industry.?I remember the angst over the index composition that had become heavily weighted towards a few stocks and what that meant for how we built portfolios for our clients.?You see, diversification is one of the main tenants of portfolio management and an important part of risk control.?As active rather than passive managers, we want to deliver performance over time that also includes reasonable amounts of risk for an investment in large U.S. companies.?When the index becomes heavily concentrated at the top, and those top names are producing outsized performance, it becomes very difficult for an active manager to outperform the index and maintain diversification.?As it turned out, the late 1990s were the easy days. We only thought the index was challenging back then.?We have an even more difficult situation today.?At least in the late 1990s, two of the top five weighted companies in the S&P 500 were not technology names.?Today, all top five companies in the index are tech or tech-related and total 21.3% of the index versus the 16.5% top five concentration at the peak in 2000.?Practically, this means an active manager is unlikely to even match the index’s investment performance when these stocks are among the best performers unless the manager over-weights these already heavily weighted companies within the index.?Constructing a portfolio this way would produce an even greater concentration in this handful of companies and less diversification for clients’ investment portfolios.?The pressure to outperform the benchmark index each and every year is great, but it is also unrealistic, can cause excessive short-term risk taking, and run up sizeable capital gains tax bills in taxable accounts.

Given these heavy weights in the S&P 500 Index today, you may ask what this has meant for the performance of the index and actively managed portfolios so far in 2023.?The Wall Street Journal published an article on April 10, 2023 on just this topic.?In “Stock Pickers Failed to Take Part in First-Quarter Rally”, Data was cited that revealed only a third of active, large-cap mutual funds beat their benchmarks in the first quarter of 2023.2?The article goes on to compare the first quarter’s results to 2022 when 57% of actively managed funds beat their benchmarks.3?The difference between 2022 and the first quarter of 2023 can be described as a narrowness of market performance.?During 2022, almost every sector of the market was down broadly except for energy. The experience so far in 2023 has been narrow performance where the S&P 500’s rise has occurred at the hands of a few stocks with large weights in the index. Comparing the performance of the equal weighted S&P 500 to the market capitalization weighted index shows the difference.?The average stock did better than the index in 2022.?So far in 2023, that has not been the case.

While no one likes to underperform a popular market benchmark over any time period, it is important to recognize that sources of performance within the index can and do change dramatically over very short periods of time.?Fifty-nine percent of the S&P 500’s rise year to date as of April 19, 2023 has come from only five, heavily-weighted stocks in the index.?A portfolio that outperformed the benchmark in 2022, is likely underperforming so far this year. This has little to do with the longer-term outlook for the individual companies within the index and more about the shorter-term macro economic environment and a market that expects slower growth, possibly a recession, and potentially interest rate cuts by the end of 2023.?Should the Fed not deliver on the expected interest rate cuts in the fall, the composition of S&P 500 index performance could change dramatically by the year’s end.

Speaking of the Fed… The Federal Reserve meets again on May 2nd and 3rd with its decision on interest rates announced the afternoon of the 3rd.?As of this writing, the futures markets expect the Fed to raise Fed Funds interest rates by another 0.25% to a range of 5.00%-5.25%.4?The probability of this outcome is around 85%.4?A target rate at this level would place Fed Funds on top of the median expected rate from the Fed’s March 2023 Summary of Economic Projections.5?Not surprisingly given this consistency, the futures markets expect the Fed to stop its interest rates increases after next week’s meeting.?However, inconsistent with the Fed’s projections of no interest rate cuts during 2023, the futures markets are contemplating the idea of interest rate cuts beginning in the fourth quarter of 2023.4?This expectation has increased since the failures of Silicon Valley Bank and Signature Banks.?These types of events serve to tighten financial conditions and lending standards.?Everyone suddenly becomes risk averse, and this magnifies pressure on the economy.?The Fed has done a great deal, and now the decline in risk taking is gaining in momentum.?The combination of much higher interest rates and much tighter lending standards raises the risk of that hard landing recession no one wants.?The Senior Loan Officer Opinion Survey last released on March 31, 2023 shows just how risk-averse lending standards have become.?Lending standards were already tightening after bottoming the first part of 2021.?But they have taken another leg higher (tighter) during the first quarter.?This is for many types of loans, but commercial real estate lending seems to be experiencing the most tightening with lending standards for that sector returning to near-peak pandemic levels of caution.

Company Earnings

First quarter earnings reports are releasing in rapid succession.?As of Friday, April 21st, 17.9% of S&P 500 companies had reported with earnings growth so far of 0.53% compared to a year ago.1?The strongest earnings growth so far has come from Industrials, Energy, Real Estate, Financials, and Consumer Discretionary.1?Negative earnings comparisons versus a year ago have been reported by Consumer Staples, Health Care, Communication Services, Info Tech, and Materials.1?The earnings season is still young, so there is much more to come.?So far, earnings have generally been better than feared.?Expected earnings comparisons for the first quarter versus a year ago sits at -0.47% and we’re at +0.53%.1?We still see signs of profit margin pressure in the pipeline.?The grey shaded part of the chart below represents profit margins.?They peaked early in 2022 and have been declining since.?The red line is yearly revenue growth for the S&P 1500 Index, which includes large, medium, and small

companies.?Changes to input costs are represented by the Producer Price Index (PPI) in light blue and the Consumer Price Index (CPI) in dark blue.?The yellow line is labor costs or the Employment Cost Index (ECI).?When sales growth is declining faster than input and labor costs, contracting profit margins are the result.?If there is any good news on this chart it is that PPI and CPI seem to be falling as fast as sales growth now, assuming sales growth doesn’t take another leg lower.?That is the first step to stabilizing profit margins, but it is still early to expect improvement in margins.?Employment costs will be the last line to ease. Earnings reports are ramping up again for this week, so we’ll hear from many more companies on their outlooks for sales growth, input costs, margins, and hiring or layoffs.?Meanwhile, with the Fed meeting is front and center, don’t expect much out of the financial markets until we hear more from the Fed.?We wouldn’t expect much change in its outlook or official statement.

Tracy Bell, CFA

Director of Equity Investment Strategies, First Horizon Advisors

Footnotes

1. FactSet??

2. Securities & Exchange Commission: https://www.sec.gov/Archives/edgar/data/357298/000035729801500016/sp500.html

3. https://www.wsj.com/articles/stock-pickers-failed-to-take-part-in-first-quarter-rally-db2f910f

4. CME Fedwatch Tool: https://www.cmegroup.com/markets/interest-rates/cme-fedwatch-tool.html

5. Federal Reserve: https://www.federalreserve.gov/monetarypolicy/files/fomcprojtabl20230322.pdf

Index Definitions:

S&P 500 Index is a stock market index tracking the stock performance of the 500 largest companies listed on the stock exchanges in the United States.?It is one of the most commonly followed equity indices.

S&P 500 Equal Weighted Index is the equal weighted version of the widely-used S&P 500.?The index includes the same constituents as the capitalization weighted S&P 500, but each company in the S&P 500 EWI is allocated a fixed weight at 0.2% of the index total at each quarterly rebalance.

S&P 1500 Composite Index combines three leading indices, the S&P 500, the S&P Midcap 400, and the S&P Smallcap 600 to cover approximately 90% of U.S. market capitalization.?It is designed for investors seeking to replicate the performance of the U.S. equity market or benchmark against a representative universe of tradable stocks.

Producer Price Index (PPI) is a family of indexes that measures the average change over time in the selling prices received by domestic producers of good and services.?PPIs measure price changes from the perspective of sellers.

Consumer Price Index (CPI) is a measure of the average change over time in the prices paid by urban consumer for a market basket of consumer goods and services.

Employment Cost Index (ECI) is a quarterly measure of the change in the price of labor, defined as the compensation per employee hour worked.

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Content should not be regarded as a complete analysis of the subjects discussed.?All expressions of opinion reflect the judgement of the author on the date of the publication and are subject to change.?All investment strategies have the potential for profit or loss.

First Horizon Advisors is the trade name for wealth management products and services provided by First Horizon Bank and its affiliates. Trust services and financial planning provided by First Horizon Bank. Investment management services, and investments, available through First Horizon Advisors, Inc., member FINRA, SIPC, and a subsidiary of First Horizon Bank . First Horizon Advisors does not offer tax or legal advice. You should consult your personal tax and/or legal advisor concerning your individual situation.

Information presented is as of the close of business for the noted date, compiled from third party sources and believed to be reliable. However, we do not warrant its accuracy or completeness. We use this information for illustrative purposes only and it does not represent the performance of any particular investment. This information does not constitute and should not be construed as investment advice or recommendations with respect to the securities or sectors listed.