Tom Yeung, CFA, is a registered investment advisor on a mission to bring simplicity to the world of investing.
Years ago, academics came up with groundbreakingly dull investment advice: buy stocks for the long run and keep adding to your portfolio over time. Punters and Wall Street bigwigs understandably balked at such simplicity. Buy-and-hold strategies with the S&P 500 index, after all, donâ€™t generate brokerage fees. And it leaves stock analysts with little to talk about at cocktail parties.
2020, however, saw something strange: last year, retail investors beat the market hands down.
With the S&P 500 still at record highs (and not to mention record valuations), long-term investors are rightly asking themselves: â€œis it still the right time to buy the index?â€ And for the second year in a row, the answer could be â€œno.â€ With S&P valuations still bursting at the seams, hereâ€™s why Robinhood investors will outperform the S&P 500 index again.
- Historical data working against the S&P 500;
- S&P 500 concentrated in mega-cap tech companies; and
- Investors should seek higher growth opportunities.
S&P 500 Index: Reaching its Upper Limits
Institutional investors can excuse themselves for missing out on 2020â€™s biggest winners.
Speculative companies, from electric vehicle startups such as Nikola (NASDAQ:NKLA) to blockchain firms, took center stage as retail investors discovered the joys of making a lot of money with relatively little effort. Thus emerged a curious case of retail investors dragging the S&P 500 up, rather than the other way around. Massive gains in popular mom-and-pop stocks, from Appleâ€™s (NASDAQ:AAPL) 83% return to Netflixâ€™s (NASDAQ:NFLX) 64% gains, drove the S&P 500 up 16%.
But will the S&P 500â€™s performance continue in 2021? Donâ€™t count on it.
Consider the stock marketâ€™s history. Consecutive rises of >15% have only happened nine times since 1928 (the latest being 2019-2020). And on average, the third year saw a lower return than average: 4.9% vs. 7.7%. Volatility was also higher, at 24% vs. 19%. In other words, high stock market returns tend to get followed by lower, more volatile returns.
S&P 500 Dogged by Mega-Cap Legislation
The S&P 500 index however, faces an even bigger issue in 2021: its constituents.
Investors like to think of the S&P 500 index as a diversified mix of Americaâ€™s top companies. In a sense, thatâ€™s technically true â€” the index assigns weights based on market capitalization. The larger the company, the heavier itâ€™s weighting in the S&P 500. Itâ€™s a strategy that works well in good times since winning stocks generally keep winning.
But that also makes the S&P 500 index prone to bubbles because the most overvalued companies get overrepresented. And with the rise of mega-cap tech firms, the S&P 500 now looks more like a big-tech index than a diversified fund. Since 2019, the top five tech giants have made up a quarter of the S&P 500 index.
Thatâ€™s a big problem. With the large tech firms reaching their upper limits, the S&P 500 will struggle to keep growing. Apple, the S&P 500â€™s largest constituent, is now worth $2.2 trillion, or more than all of Floridaâ€™s real estate combined. And thereâ€™s more.
In October, the U.S. Justice Department filed a civil antitrust lawsuit to break up the worldâ€™s largest search engine. Two months later, another suit targeted Facebookâ€™s anti-competitive behavior.
In a sense, 2020 looks much like the year 1999, when behemoths like TimeWarner/AOL dominated the markets. Thatâ€™s also the time period when the U.S. Department of Justice broke up Microsoft (NASDAQ:MSFT), the tech monopoly of its day. As momentum strategies came crashing down in the early â€™00s, mega-cap stocks suffered and the S&P 500 notched three years of straight losses.
Retail Investing Provides a Way Out
But donâ€™t despair. For the second year in a row, Robinhood stocks look set to beat the market. Thatâ€™s because mom-and-pop investors tend to focus on two core areas:
- Cyclical Value:Â Carnival (NYSE:CCL), American Airlines (NASDAQ:AAL), Ford (NYSE:F), and other stocks set to recover post-pandemic.
- Hyper Growth:Â QuantumScape (NYSE:QS), Nio (NYSE:NIO), Airbnb (NASDAQ:ABNB) and other high-growth companies.
These strategies offer a surprisingly good alternative to traditional S&P 500 investing. With value stocks, people bet on a reversion to the mean â€” under-represented, under-loved companies that could make a phenomenal comeback as the world goes back to normal. And with hyper-growth companies, investors are buying high-potential companies with room to grow 10x, 100x or even 1,000x.
The Jekyll-and-Hyde strategy might seem odd at first. How can investors believe in both value and growth investing at the same time? But combining the polar opposite ends of the investing spectrum has been a winning formula in 2020. Investors buying Tesla (NASDAQ:TSLA) with one hand and Delta Airlines (NYSE:DAL) with the other would have tripled their money since May. For 2021, you can expect more of the same.
On the date of publication, Tom Yeung did not have (either directly or indirectly) any positions in the securities mentioned in this article.