Why are Wall Street and Main Street going in Different Directions

September 21, 2020

In “Why Is the Stock Market So Strong When the Economy Is Weak?” (Knowledge@Wharton, Aug 31, 2020), Wharton finance professor Itay Goldstein identifies three (3) factors for the disconnect between Wall Street and Main Street:

1. “The stock market is meant to be forward-looking”
2. “that the Fed started injecting all this money into the market pushed prices up”
3. “the stocks that are doing well – Google, Facebook, Amazon, Microsoft, Netflix – haven’t been hurt that much by the current economic conditions”

In this blog, I would like to focus on the third factor.

If we focus on the S&P 500, we can see just how much influence the largest stocks (defined by market capitalization) has on this index.

The S&P 500 is a good proxy for the stock market because it represents a broad swath of the stock market. The ETF of the S&P 500 that is often used is the SPDR® S&P 500 ETF Trust (symbol: SPY). It is a market capitalization weighted ETF. And by that I mean that the fraction of the index for a company in the index is equal to the market cap of that individual company divided by the sum of the market caps for all the companies in the index. Market Cap is defined as the total number of outstanding shares a company has multiplied by the current price of a single share.

If we look at the top 5 companies (by market capitalization) that make up the S&P 500 index, we can see that they make up over 22% of the market valuation of the index and have an average YTD % return that is nearly 3 times that of the index as a whole.

Another way of seeing how much of an oversized influence those large market capitalization stocks have on the index, is to compare an S&P 500 market capitalization weighted index to its equal-weighted counterpart. An equal-weighted index, as its name implies, weights each stock equally in the index. If you had 500 stocks and the total value of the index is $1,000, then you would invest $2 into each stock. An ETF that is the equal-weighted version of the S&P 500 is the Invesco S&P 500® Equal Weight ETF (symbol: RSP).

Finally, if we graph the 12 month returns for the equal-weighted vs the capitalization weighted ETFs for the S&P 500 for 5 years, we can see that the capitalization weighted ETF (SPY) outperformed the equal-weighted ETF (RSP), especially for the last 12 months (ending on 9/9/2020).

In conclusion, the returns that you are seeing are predominantly from the largest capitalization Technology stocks and not necessarily from the stock market as a whole. And while these stocks have propelled the S&P 500 index up in the last 12 months, they could also drag the market down in the next 3 months.