The Index Is Not the Market, and the Market Is Not the Economy
I recently heard someone use the phrase, “The map is not the territory.” This is an interesting way of stating the truth that looking at a map of an area doesn’t tell you everything about the area. For example, a map can’t tell you what it’s like to drive a particular stretch of highway on a rainy day or at night. And it certainly can’t tell you the sounds, sights, and sensations you will experience while hiking a particular trail. A map can only provide an overview, a general orientation. Looking at a map is not the same as actually traveling the territory.
In many ways, the same is true when we talk about financial indicators like stock indexes. Many know that the Standard & Poors 500 (S&P 500) index, one of the most widely watched indicators of market conditions, is actually an aggregate composed of about 500 of the largest companies in America, weighted by market capitalization. While it is a much broader index than the Dow Jones Industrials Average (DJIA or “the Dow”), which is made up of only 30 companies, there are still limitations to what the S&P 500 can tell us about the broad scope of business in America.
Because the S&P 500, which is currently just off its high for the year and up about 8%, is weighted by market capitalization, the index is affected more by the price movements of companies like Amazon, Apple, Facebook, Netflix, and Alphabet (formerly Google). These companies are so large that an index like the S&P 500 is highly influenced by their performance. These five tech stocks alone, all of them up strongly during 2020, now make up about 15% of the market capitalization of the S&P 500 index.
But what about other important industry segments like real estate, medium-capitalization companies, or small-capitalization companies that employ millions of Americans and make up part of the other 85% of the capitalization of the S&P 500? And what about foreign corporations whose stock is owned by hundreds of thousands of American investors by means of international mutual funds and other vehicles? According to the Wilshire Real Estate Investment Trust Index, the real estate sector has lost almost 16% of its value this year.
Similarly, the Wilshire Small Cap Value Index is down about 13% for the year. The Europe, Australia, and Far East (EAFE) Index of large-capitalization foreign stocks is down almost 11% for the year. Clearly, the S&P 500 is not telling us the whole story.
This helps to explain why, though a rising S&P 500 is certainly an encouraging indicator, it is only a single data point. A rising S&P 500 is good for many portfolios, but the U.S. still has an unemployment rate of almost 7% (and for some sectors of the population, it is more than 11%). Many small businesses are struggling to survive amid the limitations imposed by the pandemic. Just as it is not an indicator of the entire stock market, the S&P 500 is also not a proxy for the U.S. economy.
These facts are not meant as a prediction of doom. They are, however, important for understanding the broader factors underlying both the financial markets and the U.S. and world economies. As we continue to work our way through a worsening pandemic while we wait for a vaccine and the hoped-for turnaround in infection rates, we need to keep in mind that there are still problems to be solved. Caution, on both a personal and national level, is still advised.
If you would like to know how the current financial and economic environment could affect your investments, please contact us. And to learn more about how your saving and spending behavior is affecting the U.S. economy, you can read our recent article, “Americans Are Saving More During the Pandemic: Is That Good or Bad?” by clicking here.