Financial Markets Review

The month of May marked a robust rebound in the major US equity indices, following a lackluster April. All major indices advanced with the Nasdaq leading the way, rising 6.9%. Not to be outdone, the S&P 500 and Russell 2000 advanced 4.8% and 4.9%, respectively. However, concentration worries resurfaced as the equal-weight S&P 500 lagged with a 2.8% increase. Notably, both the S&P 500 and Nasdaq registered five consecutive weeks of gains before experiencing a pullback in the final week of the month.

The equity pullback was short-lived though, as the S&P 500 rose 1.3% and the Nasdaq climbed 2.4% in the first week of June with both indices setting record highs. However, as has been the case for a while now, not all companies participated in the record-setting week, as seen by the equal-weighted S&P 500 and the small cap Russell 2000 index falling 0.7% and 2.1%, respectively.

There is nothing to sneeze at when markets are busting through to new all-time highs. However, it’s the nuances as to how the S&P 500 and Nasdaq are doing it that are a tad bit concerning. It’s been well documented for over a year now that a handful of the largest companies are responsible for most of the market’s gains. As the S&P 500 rallied strongly in May, only 36% of S&P 500 constituents were above their 50-day moving averages at the end of month, which was similar to April’s figure. In addition, over half of the S&P 500’s advance in May was due to only four companies – Nvidia, Apple, Microsoft and Alphabet. This divergence is once again proof that the record-setting gains are being experienced by just a few and not enjoyed by the masses.

Lastly, to put the most recent market concentration in perspective, during the height of the Tech Bubble, the top 10 largest companies made up 27% of the S&P 500. Today, the top 10 companies make up nearly 36% of the S&P 500. And what is even more staggering, the top 5 companies – Microsoft, Nvidia, Apple, Amazon and Meta– make up 26% of the index. As the S&P 500 broke through to all-time highs, only two sectors were doing the same – Information Technology and Communication Services. Today, these two tech-laden sectors comprise over 40% of the S&P 500; whereas the Information Technology sector made up roughly 33% of the S&P 500 in 2000.

None of these comparisons are meant to imply a repeat of the Tech Bubble is in the cards. There are many differences between now and then with the most glaring being that the largest companies today generate huge profits. The revenues and profits that these companies are making do justify their outperformance relative to all other companies. In 2023, S&P 500 earnings grew 1%. The Magnificent 7 cohort contributed roughly 6% growth, meaning the other 493 companies posted an aggregate earnings decline of 5%. The S&P 500’s Q1 2024 earnings have come in better than expected, posting nearly 6% growth. However, all the earnings growth can be attributed to the Magnificent 7 names. After stripping out the earnings growth contribution of these companies, the other 493 companies posted an aggregate earnings decline closer to 2%.

Although there are many legitimate reasons for the S&P 500 index to get increasingly more concentrated amongst a handful of the very largest companies, at some point the risks in owning these companies, or the index through passive strategies, outweigh the potential reward. One of the many reasons index funds have become so popular is for the diversification one inherently receives when investing in a pool of 500 companies as opposed to investing in just a few companies. However, as the S&P 500 index becomes ever more concentrated, the intended diversification benefits to investing in the index begin to dwindle. As always, it is vital to know what you own, so that you can identify and understand the risks associated with the investment strategy.

Tandem Strategy Update*

As we have noted over the past few months, economic data and financial markets, outside of the S&P 500 and Nasdaq, have been quite mixed. In the previous section to this edition of Observations, we laid out the case for earnings growth of the S&P 500 being single handily propped up by the strength in the Magnificent 7. The same can be said for the lack of volatility at the index level versus the underlying constituents. The persistent strength of the Magnificent 7 has allowed the S&P 500 to trudge higher with relative ease. However, when you look under the hood, it’s anything but the case. In fact, James Mackintosh of the WSJ recently wrote:

“Under the calm surface, however, there is furious paddling. Only once in the past 25 years have stocks swung about like this while the overall market stayed so placid… The result is far more stocks with 10% swings in a day over the past three months than at almost any other time when the market can barely get above an average move of 0.5%.” – James Mackintosh, WSJ, June 9, 2024

At Tandem, this has translated to higher transaction activity despite extremely low levels of headline index volatility. In the past, during periods of such low index volatility, we would be hard pressed to find opportunities to buy or sell stocks. So far this year, that has not been the case. We’ve had opportunities to add to core positions, to trim positions for valuation purposes and liquidate companies that no longer met our growth criteria.

Over the past several weeks, we have had the opportunity to trim our long-time core position in Republic Services (RSG) held within all three of our strategies. Republic’s business is as simple as it gets – the company is the second largest provider of waste disposal and recycling in the United States. RSG continues to meet our criteria of consistent revenue, earnings and cash flow growth; however, our quantitative model signaled it was an opportune time to trim the position for valuation reasons.

In addition, we had the opportunity to finish up the liquidation of AbbVie (ABBV), which was another long-time core position held in our Large Cap Core and Equity strategies. The patent cliff of the best-selling drug of all-time, Humira, loomed over ABBV for many years. To replace the inevitable drop in revenue, ABBV acquired several different biotechnology and pharmaceutical companies; however, the growth has taken too long to materialize, and the expectation is that it could be another few years before the company gets back to where they were before the Humira patent expiration. For this reason, ABBV no longer met our criteria for consistent growth and had to be liquidated from our strategies.

*The transition level activity taken by Tandem is applicable to new accounts and new money, not the composite or firm-wide level. New accounts and new money are not automatically invested on the first day. Rather, they are transitioned into our strategy over a longer time period that is dependent upon market conditions. Strategy level activity is applicable to the composite and action is taken at the firm-wide level.

Source: Source of all data is FactSet, unless otherwise noted.

Disclaimer: Tandem Investment Advisors, Inc. is an SEC registered investment advisor.

This audio/writing is for informational purposes only and shall not constitute or be considered financial, tax or investment advice, or an offer to sell, or a solicitation of an offer to buy any product, service, or security. Tandem Investment Advisors, Inc. does not represent that the securities, products, or services discussed in this writing are suitable for any particular investor. Indices are unmanaged and not available for direct investment. Please consult your financial advisor before making any investment decisions. Past performance is no guarantee of future results. All past portfolio purchases and sales are available upon request.

All performance figures, data points, charts and graphs contained in this report are derived from publicly available sources believed to be reliable. Tandem makes no representation as to the accuracy of these numbers, nor should they be construed as any representation of past or future performance.​