The S&P 500 is up 25% for the year. Yet depending on who you ask, that number can seem way too low or way too high.
Something strange is happening in the market. At first glance, it's hard to put a finger on what exactly it is. But dig deeper with the help of some visual aids, and at least some of your questions could be answered.
Below, you'll find three charts that I believe help explain why things feel out of balance in the U.S. stock market right now. Taken together, the three charts tell the story of why ARK Invest CEO Cathie Wood's strategy failed this year after working to near-perfection in 2020.
1. Volatility is on the rise
Volatility has picked up in December. In fact, it's the highest it's been since early April.
The above chart shows the 30-day rolling volatility for the SPDR S&P 500 ETF Trust (SPY 0.22%), the Fidelity Nasdaq Composite ETF (ONEQ 0.29%), and the SPDR Dow Jones Industrial Average ETF (DIA 0.01%). This forward-looking metric takes the last 30 days of trading data to extrapolate what the standard deviation of a security will be over the next year. The data shows it's more likely that the prices of all three exchange-traded funds could be further from their mean than any point since April. In short, there's more volatility.
2. Mega-cap stocks have now become even more mega
Throughout 2018, there was a lot of buzz around which U.S. company would be the first to pass a $1 trillion market cap and stay above that point. Today, there are nearly six companies worth over $1 trillion (Meta Platforms (META -0.10%) and Tesla (TSLA 1.70%) were above $1 trillion but slipped recently).
What's more, the cumulative value of the seven largest U.S. stocks by market cap -- Apple, Microsoft, Alphabet, Amazon, Meta Platforms, Tesla, and Nvidia -- is $11.47 trillion. At the end of 2018 that same basket was worth just $4.74 trillion. That's a staggering 242% return in just three years from what many would consider rather obvious picks. And get this: Apple and Microsoft combined are worth more than the value of all seven stocks just three years ago.
Has the world changed that much? In some ways, yes. It's undeniable that many of the trends these companies are behind -- e-commerce, software, data and IT service management, modern advertising, electric vehicles, graphics and processing power, virtual reality, and renewable energy (among others) are growing extremely fast. But it's also true that the value Wall Street is willing to give these companies, both in terms of the market cap of the stock relative to its revenue (P/S ratio) or the price of the stock to its earnings (P/E ratio) has expanded in recent years. This phenomenon is called "multiple expansion." The opposite is "multiple contraction" which is when investors are willing to pay less for a company relative to its sales or earnings.
It wasn't long ago that Apple and Microsoft had 1% or 2% dividend yields and sub-20 P/E ratios. Today, they each have less than a 0.8% dividend yield and a P/E ratio above 30.
3. There's been a shift from growth at any price to growth at a reasonable price
Sometimes the simplest charts carry the most weight. And that's why the chart below may be the best one on this list.
Here, we see the year-to-date return of the S&P 500, the Vanguard Small-Cap Growth ETF (VBK 1.71%), and Cathie Wood's flagship Ark Innovation ETF (ARKK 1.47%). The staggering year-to-date performance of these different investment vehicles reflects what we've learned in the previous chart. The bulk of the market's gains has been driven by mega-cap stocks -- and not just tech stocks, but many blue chip stocks, too. In fact, the top 10 stocks in the S&P 500 contributed around half of its gains so far this year. If you don't own those, then there's a very high chance you're underperforming the market.
What's more, many of Cathie Wood's favorite companies, which are mostly ultra-high growth, but also highly unprofitable companies in disruptive industries, are completely out of favor right now because their growth has slowed and they are losing money.
Last year, Wood was one of the most popular if not the single most praised stock picker around. Deservingly so -- all five of her exchange-traded funds posted over 100% returns in 2020. This year, all five of her ETFs have lost money.
Focus on what matters most
It's been hard for Wood's picks to beat the market when the bulk of market gains are driven by the largest companies. In fact, it's been very hard for any fund, let alone an individual investor, to beat the 2021 U.S. stock market because of the disparity between mega-cap companies and everything else.One single year of performance isn't indicative of an investor's prowess. Trying to mimic what Mr. Market favors over a short-term time period is a good way to lose your shirt. If you did that in February, you would have overpaid for meme stocks. Knowing what you own and why you own it provides the confidence needed to let a growth story play out.
Investors will likely disagree about whether 2021 market dynamics make sense or not. But either way, it's clear the market has shifted heavily toward well-known industry-leading names that are either profitable or have a clear path to profitability. Hopefully, by now you've gained a better understanding of why this year has truly been a year of both sizable returns and catastrophic losses.
No matter how interesting the narrative is, the most important thing is to invest in companies that match your personal risk tolerance and financial goals. For many, Wood's stocks are a poor fit. And for some, jumping into mega-cap stocks that have increased in value by so much could also be a bit uncomfortable. The best option for 2022 could be to find quality blue chip value stocks that are trading at a discount compared to past prices. That way, an investor gets a quality business they know can outlast market volatility, but that also isn't terribly overvalued.