These 6 overvalued stocks are making the S&P 500 look more pricey than it really is – MarketWatch

Its impossible to know which stocks will dominate the stock market in a decades time, but we can fairly confidently say which companies will not be on that list: stocks that currently top todays market-cap ranking namely Apple AAPL, +2.80%, Microsoft MSFT, +2.83%, Amazon.com AMZN, -1.12%, Alphabet (Google) GOOG, +0.38% and Meta Platforms (Facebook) FB, -0.02%.

Thats because its rare for stocks at the top of the market-cap ranking to keep their status a decade later. Not only do they usually fall out of the top 10, they also underperform the market on average over the decade.

Thats according to an analysis conducted by Research Affiliates, the investment firm headed by Robert Arnott. To show the precarious position of the markets top dogs, he calculated what happened over the decade of the 1980s to the 10 largest publicly traded companies at the beginning of that 10-year period. Eight of the 10 were not on 1990s top-10 list, and all 10 on 1980s list underperformed the world stock market over the subsequent decade.

Arnott found that the 1980s were not unique. He reached a similar result for the top stocks of the 1990s, 2000s, and 2010s. On average, a stock on any of these lists underperformed the market over the subsequent decade. In addition, there was between a 70% and 80% chance that any given stock would not be on the comparable list one decade hence.

Arnott illustrated these top companies underperformance in another way as well: He constructed a hypothetical portfolio that each year owned the worlds 10-largest companies. The performance of this portfolio is plotted in the chart below. Over the 40 years from the end of 1980 through the end of 2020, this portfolio lagged a buy-and-hold by 1.8 annualized percentage points.

Numerous investment lessons can be drawn from Arnotts fascinating results. One is that cap-weighting is not the optimal weighting scheme for your portfolio. Equal-weighting is one obvious alternative, and it has beaten cap-weighting: since 1971, according to data from S&P Dow Jones Indices, the equal-weighted version of the S&P 500 SPX, +0.95% has outperformed the cap-weighted version by 1.5 annualized percentage points.

Arnott believes there are even better ways of weighting stocks in an index beyond equal weighting. His firm maintains a number of so-called fundamental indices that base a stocks weight on fundamental characteristics such as sales, cash flow, dividends and book equity value.

Just six stocks Apple, Microsoft, Alphabet, Amazon, Tesla and Meta Platforms account for 26% of the S&P 500s total market cap

But theres another investment implication of Arnotts data that I want to focus on: His results highlight the difficulties determining the valuation of a lopsided market.

Consider the S&P 500 currently, in which just six stocks Apple, Microsoft, Alphabet, Amazon, Tesla TSLA, +1.32% and Meta Platforms account for 26% of the indexs total market cap. Imagine a situation in which those six are overvalued while the other 494 stocks, on balance, are more fairly valued. In that case, the valuation ratios for the S&P 500 as a whole could paint a skewed picture.

This situation isnt just hypothetical. The largest six stocks currently have an average price/earnings ratio of 62.0, according to FactSet, more than double the average across all stocks in the S&P 500 of 29.1 and almost triple its median P/E ratio of 21.4.

Its possible, therefore, that the stock market isnt as overvalued as we would otherwise think by focusing on valuation ratios for the S&P 500 as a whole.

Mark Hulbert is a regular contributor to MarketWatch. His Hulbert Ratings tracks investment newsletters that pay a flat fee to be audited. He can be reached at mark@hulbertratings.com

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These 6 overvalued stocks are making the S&P 500 look more pricey than it really is - MarketWatch