Market Perspectives – October 2014

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Overview: Looking at the S&P 500 (+6.9% total return through 10/1), one might surmise the U.S. equity markets are off to a strong start. However, this headline performance overstates the true strength of the domestic stock market. The driving theme that emerges when taking a deeper dive is U.S. large capitalization stocks are significantly outperforming smaller capitalization stocks. This is evident among companies within the S&P 500 and is even worse when looking at small-cap only indexes such as the Russell 2000. For example, over the same time period, the total return of the Russell 2000 is negative 5.8%. This month we look below the surface of equity performance within the U.S.

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There are several different ways an index can be constructed. Today we will discuss two of the primary ones: • Price-Weighted Index: This type of index is comprised of an adjustment factor where each

component makes up a percentage of the index based on the current stock price. For example, a stock with a price of $100 might make up 10 times the weight of a stock with a $10 stock price (subject to an adjustment factor). The Dow Jones Industrial Average and the Nikkei 225 are relevant examples.

• Cap-Weighted Index: This type of index weights the components based on the total market value of the outstanding shares of the company. A common version will utilize the “free-float” (~ freely tradable) shares in order to specifically take into account the tradeable market capitalization and the S&P 500 is such an index. This type of index is the most common (and in our view the most logical). We will spend the rest of this month’s analysis on this type of index.

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An Index Refresher

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Larger Companies Have Driven Performance This Year

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Larger companies, such as Apple, Microsoft, and Berkshire Hathaway, have driven performance for cap-weighted indices such as the S&P 500:

• As shown on the left, while the total return for the S&P is 6.9% through 10/1, the largest 20 companies are actually up 9.3% on average.

• When taking into account market cap among the largest 20, the differential is even greater at 10.2%.

• At the other end of the spectrum, the smallest 100 companies in the S&P 500 have returned just 3.3%.

Company Market Value YTD TR Performance Weighting in Top 20 Weighted Performance

1 APPLE INC 593,876,649,060$ 25.8% 11.2% 2.9%

2 EXXON MOBIL CORP 396,019,301,720$ -6.3% 7.5% -0.5%

3 GOOGLE INC-A 387,903,611,269$ 3.3% 7.3% 0.2%

4 MICROSOFT CORP 378,209,059,415$ 25.2% 7.1% 1.8%

5 BERKSHIRE HATH-B 336,506,874,426$ 15.2% 6.3% 1.0%

6 JOHNSON&JOHNSON 294,155,968,102$ 16.3% 5.5% 0.9%

7 WELLS FARGO & CO 267,598,065,229$ 15.3% 5.0% 0.8%

8 GENERAL ELECTRIC 252,453,018,451$ -7.9% 4.8% -0.4%

9 WAL-MART STORES 245,297,706,230$ -1.4% 4.6% -0.1%

10 PROCTER & GAMBLE 225,114,215,298$ 4.5% 4.2% 0.2%

11 CHEVRON CORP 223,409,329,211$ -3.3% 4.2% -0.1%

12 JPMORGAN CHASE 224,811,759,991$ 4.9% 4.2% 0.2%

13 VERIZON COMMUNIC 204,898,824,334$ 3.9% 3.9% 0.2%

14 FACEBOOK INC-A 198,085,812,500$ 40.0% 3.7% 1.5%

15 IBM 186,719,324,962$ 1.5% 3.5% 0.1%

16 PFIZER INC 184,836,160,123$ -2.3% 3.5% -0.1%

17 COCA-COLA CO/THE 187,454,385,093$ 5.8% 3.5% 0.2%

18 AT&T INC 181,302,560,000$ 3.4% 3.4% 0.1%

19 BANK OF AMERICA 176,876,808,915$ 8.5% 3.3% 0.3%

20 INTEL CORP 168,284,490,000$ 34.2% 3.2% 1.1%

TOTAL VALUE 5,313,813,924,329$

Average 265,690,696,216$ 9.3% Weighted Average 10.2%

S&P TOTAL RETURN 6.9% as of 10/1 close

Bottom 100 Companies in the S&P 500 Performance 3.3%

Average Market Cap of the Bottom 100 Companies in the S&P 500 6,495,781,346$

• The Russell 2000 Index, which targets the smallest companies in the Russell 3000 (and generally have market caps under $2 billion), is down 5.8% year to date, including dividends.

• This broad cross section of the markets is reflective of a general undertone of underperformance from equities other than at the mega-cap level.

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Smaller Capitalization Companies Have Performed Even Worse

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Market Perspectives – October 2014

Experience Insight Impact

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Conclusion: While year to date performance at the U.S. large cap index level may look reasonable, we conclude the true underlying conditions are being masked by the mega-caps (such as Apple, Microsoft, and Berkshire). We continue to believe that from a valuation perspective, small and mid-cap domestic equities look expensive relative to larger companies and we continue to heavily weight our portfolios toward large-cap securities.

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Opinions expressed in this commentary may change as conditions warrant and is for informational purposes only. Information contained herein is not intended to be personal investment advice for any specific person for any particular purpose. We utilize information sources that we believe to be reliable but cannot guarantee the accuracy of those sources. Past performance is no guarantee of future performance; investing involves risk and may result in loss of capital. Consider seeking advice from a professional before implementing any investing strategy.

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Disclaimer

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