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Here's the Shocking Reason for the S&P 500's Strong Gains

When it comes to stock market participants, day traders and index investors are the on opposite ends of the spectrum. The first group conjures images of boiler rooms full of traders scanning multiple computer screens, looking for short-term price movements to quickly profit.

Index investors, on the other hand, are not interested in day-to-day price gyrations and other market minutiae. They understand in the long run it's nearly impossible to beat the stock market by excessively trading and are willing to accept the broader market's returns to fund their retirement.

It might appear these two groups have nothing in common, but both surprisingly benefit from a common investment strategy: momentum. Here's what you need to know about how momentum factors into your index and why it's helped power the S&P 500 and Dow Jones Industrial Average higher.

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Momentum or contrarian?

There are many investment strategies, but they all boil down to two broad approaches: contrarian and momentum.

Momentum assumes the broader stock market is right and stocks that have shown a recent pattern of upward (or downward) movement will continue their trajectory. To summarize a common momentum aphorism, "the trend is your friend." Momentum investing is often associated with growth investing, as the market tends to reward stocks with a strong track record of growth.

Contrarian approaches assume the opposite: Investors fundamentally misunderstand a stock and, as a result, its price is below its true value -- or a stock has unwarranted positive sentiment and is bound to fall back to earth when sanity resumes. The contrarian approach is associated with value investing, with the most famous adherent being Berkshire Hathaway CEO Warren Buffett.

If you own ETFs that track broader U.S. indexes, you are likely taking advantage of the momentum strategy. To understand how, you must know how the underlying index is constructed. As you'll see below, some weighting systems are more conducive to momentum investing than others.

What's your weight?

Broadly, there are three approaches to weighting an index:

  • Equal Weighted: Each stock equally affects the overall return; if half the stocks in the index increased by 1% and the other half decreased by 1%, the equal-weight index would provide no return. Compared to others, equal-weighted indexes better reflect smaller companies and lower share prices and lean toward a value style as gainers are sold off to buy underperformers. Equal weighting is difficult, as these indexes require constant rebalancing and as a result are not often reflected in broad stock market indexes.
  • Price Weighted: Price weighting is conceptually easier to understand, as it would provide the same returns as if you purchased one share of every stock in the index. In a price-weighted index, stocks with higher share prices affect the index more than those with lower share prices. Rebalancing is not often needed unless companies split their stock or perform some other corporate action. The Dow Jones Industrial Index is an example of a price-weighted index.
  • Market Capitalization Weighted: Unlike the price-weighted index, the market capitalization approach uses the total value of the companies (share price multiplied by shares outstanding) in the index for weighting. If the index is initially set up to reflect the market capitalizations, it will require little rebalancing. Therefore, large-cap companies like Apple and Microsoft would impact this index more than smaller companies. The S&P 500 is a market capitalization index.

The regular rebalancing that most equal-weight indexes do make them more conducive to contrarian investing strategies. By contrast, price-weighted or market-cap weighted indexes reward those stocks that see their share prices rise with greater weightings, making them friendlier to the momentum investing concept.

Momentum isn't necessarily a bad thing

Therefore, if you own an ETF like the SPDR Dow Jones Industrial Average ETF (NYSEMKT: DIA) or the Vanguard S&P 500 ETF (NYSEMKT: VOO), stocks that are outpacing average returns will begin to affect your portfolio to a larger degree, directly via the price index of the DJIA and via its effects on the market capitalization for the S&P 500 index. This has been the reason for the S&P 500's strong gains in recent years.

As an example, in January 2020 Apple and Microsoft represented 4.9% and 4.6%, respectively, of the S&P 500 index. Because of strong 1-year returns that far outpaced the market's return of 16% -- 73% for Apple; 36% for Microsoft -- they now reflect 6.7% and 5.3% of the index. If that sounds like your portfolio is benefiting from momentum, that's because it is.

The risk with indexes that have a momentum component is they reward companies that are considered expensive by traditional valuation metrics. The most notable example is currently Tesla, which has climbed from not even being included in the S&P 500 last year to now representing 1.7% of the S&P 500.

On it's own, however, momentum is not necessarily a bad thing and index investors are clearly not in the same class as day traders. Day traders aren't foolish because they use a momentum approach, it's the other behaviors that are why many lose money -- trading excessively, making emotional decisions, and taking highly taxed short-term profits. However, if you do want to lower the momentum effect in your portfolio, there are quite a few equal-weighted indices, the most-notable being the Invesco S&P 500 Equal Weight ETF (NYSEMKT: RSP)

In the long-run, holding broad-based indexed ETFs is a smart way to plan for your financial future, but it's important to know if you invest in any ETF that tracks the Dow Jones Industrial Average and S&P 500 that your portfolio will disproportionally hold large-cap stocks and companies with share prices that have outpaced the average index gains will become a larger part of your portfolio going forward.

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John Mackey, CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool's board of directors. Teresa Kersten, an employee of LinkedIn, a Microsoft subsidiary, is a member of The Motley Fool's board of directors. Jamal Carnette, CFA owns shares of Amazon and Berkshire Hathaway (B shares). The Motley Fool owns shares of and recommends Amazon, Apple, Berkshire Hathaway (B shares), Home Depot, Microsoft, and Tesla. The Motley Fool owns shares of Vanguard S&P 500 ETF. The Motley Fool recommends UnitedHealth Group and recommends the following options: long January 2022 $1920 calls on Amazon, short January 2021 $200 puts on Berkshire Hathaway (B shares), short January 2022 $1940 calls on Amazon, and long January 2021 $200 calls on Berkshire Hathaway (B shares). The Motley Fool has a disclosure policy.

 

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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