The S&P 500 Index is considered the best measure of large-cap U.S. equities. It includes 500 companies and captures approximately 80% of the available market capitalization in the U.S. A key component of the index’s structure is that it is market cap weighted. It weights the 500 companies according to their market cap, meaning the largest companies (Apple, Microsoft, Amazon, etc.) have much higher weights than the smallest companies. In fact, Apple is currently about 7% of the index and Microsoft is 6.5%. Only the largest 15 stocks have a weighting over 1%, representing about 35% of the index. The remaining 485 names make up the remaining 65%.

Some investors track the equal-weighted index S&P 500, which has the same 500 names, each with a 0.2% weight (100% / 500). This index gives an investor a better idea of how the average stock is doing, not just the mega caps. Year-to-date, the total return for the S&P 500 is about 15% while the equal weight is about 5%. Over the last 10 years, the S&P 500 has done better than the equal weight, which intuitively makes sense, as stocks that perform well by definition have larger market caps. The 10-year compounded annual total return of the S&P 500 is about 12.6% vs 11.2% for the equal weighted index.

If we look at the last ten calendar years, the S&P 500 has outperformed by as much as 4% and under-performed by more than 6%. That makes this year’s discrepancy an anomaly given its size. This tells us that the market’s performance is being driven by a few large cap names more so than in the past. As mentioned in previous posts, artificial intelligence (AI) has been a theme driving stocks. The current AI leaders are the large tech companies which are among the largest names in the S&P 500 like Microsoft, Alphabet, Meta and Nvidia. We also dealt with a banking crisis earlier in the year which threatened smaller banks to a much greater extent than the few large Global Systemically Important Banks.

Not only is performance driven by a few names, but valuation is as well. In our previous post about the equity risk premium, we discussed that the earnings yield for the stock market was very low relative to interest rates in the bond market. This earnings yield is the inverse of the more commonly referenced Price to Earnings Ratio (P/E Ratio). So, the P/E Ratio most likely needs to come down from the current 21X multiple on the S&P 500 (based off trailing earnings). Our long-term P/E target is about 18X. Incidentally, the P/E Ratio of the equally weighted index is currently just under 18X, meaning that most large cap U.S. stocks are already trading at a normalized long-term multiple.

In conclusion, investors can’t necessarily draw sweeping conclusions about stocks based off the S&P 500, e.g., all stocks are having a strong year, or the market is expensive. As always, investors should have a handle on the underlying individual holdings and the long-term growth potential of the earnings.