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The MarketGrader 100 Index Journal

October 2, 2018

Carlos DiezCarlos Diez

U.S. Mega Cap Stocks Prove Hard to Beat in September

Amid the euphoria and end-of-quarter headlines about U.S. stocks once again hitting new highs, investors may be forgiven for thinking stocks have risen unimpeded this year. While it’s true the market has continued to defy skeptics concerned about valuations and rising interest rates (count us in the latter camp), the latest leg up in equities seems to be driven more by sentiment and money flows than by underlying fundamentals. And while we still don’t see signs of a catalyst for a swoon in equities, we do think things are a little frothy at the top (among mega caps).

September was, in our view, an anomaly in a year where investors were once again incorporating some discipline in allocating capital as the cost of money finally began to rise. With summer drawing to a close—and money managers back to work—many threw caution to the wind as portfolios got rejiggered ahead of the all-important fourth quarter, with many trailing their benchmarks. As a result money flowed freely back into mega cap stocks at the expense of heretofore market leaders, including small and mid caps, sectors sensitive to the sizzling U.S. economy such as regional banks and industrials and, yes, the fundamentally strong roster of the MarketGrader 100 Index (MGONE).

The Russell 2000 Index, a small cap benchmark, reached its high for the year on August 31st, up 10.5%, while just two days before, MGONE had hit its own 2018 high, with a price gain of 10.1% for the year. Both then proceeded to lose 2.5% and 2.7%, respectively, during September, while the S&P 500, the Dow Jones Industrial Average and the Russell Top 200 Index (the 200 largest companies in the U.S.) rose 0.4%, 1.9% and 0.7% for the month. This allowed the mega cap benchmarks to post third quarter gains of 7.2% for the S&P 500, 9.0% for the Dow and 7.9% for the Russell Top 200, well ahead of MGONE’s 3.8% and the Russell 2000’s 3.3%. Figure 1 shows how the small, mid and high quality GARP (MGONE) benchmarks rolled over at the end of the summer, while the top 200 powered along. The chart includes also the KBW Regional Bank Index, which had reached a 2018 top much earlier in the year, having gained 10.3% by June 8th.

Figure 1. Year-to-Date Performance of Select U.S. Indexes Through September 28, 2018markettur_usequities

Source: Bloomberg.

We include the Regional Banking Index in our analysis since the Regional Banks industry is the largest in MGONE, accounting for 12% of the index’s weight and, along with the index’s small and mid cap exposure, a large part of the reason for MGONE’s recent bout of underperformance. This, of course, is not the first time MGONE has trailed the large cap benchmarks as a result of its bottom-up allocation to specific industries and segments where MarketGrader is finding growth at a reasonable price, in addition to its usual underperformance to the mega cap benchmarks by virtue of its equal weighting methodology. It will also not be its last, especially when measuring performance on a monthly or quarterly basis. So, while investors ride out current market dynamics that do not favor MGONE, they should keep in mind that, as market leadership changes and money flows turn, valuations will dictate performance once again, especially as interest rates continue to rise. Case in point, through the end of the quarter, MGONE constituents traded at 17.4 times 12-month trailing earnings per share, compared to 21.2 for the Russell Top 200 Index. And looking ahead, while the 200 largest companies trade at a forward P/E of 16.4, MGONE trades at only 14.6 times next year’s earnings1. In closing, we leave our readers with Figure 2, also a year-to-date view of select benchmark performance through the end of September. Notice how only the Russell Top 200 Index (and to a lesser degree, the S&P 500) have not rolled over from their annual highs. When market gains become so concentrated in a select few, history says, look out below.

Figure 2. Year-to-Date Performance of Select U.S. Indexes Through September 28, 20182018usequitiesperformance

Source: Bloomberg.
1. Russell Top 200 Index P/E ratios sourced from Bloomberg. MGONE ratios calculated by MarketGrader.

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