If you look at Standard & Poor's 500-stock index, 1998 ranks as a lackluster year. But if you analyze many of the stocks in the index, it seems like a bloodbath.
While the S&P index is up this year, half of the 500 stocks were down 11 percent or more earlier this month, according to Travelers Group's Salomon Smith Barney. That has led many observers to carp about the narrowness of this year's market.But the truth is, you hear complaints about the market's narrowness almost every year. Stock-market gains tend to be concentrated in a relatively few companies. Loading up on the hoped-for winners, however, can be perilous indeed.
No doubt about it, this year's market has been extreme. The S&P 500 has been propped up by a handful of companies, including Lucent Technologies, Microsoft and Wal-Mart Stores, which have posted big 1998 gains even as most stocks lose money.
"It's still a very narrow market," says Jeffrey Warantz, an equity strategist at Salomon Smith Barney.
The extraordinary narrowness of the current market reflects the dominance of the very biggest stocks. But even in years when small stocks do well, the market will tend to be narrow, for a very simple reason.
A rotten stock can lose no more than 100 percent of its value, while the gain for a great stock is unlimited. In any year, these great stocks can potentially add much more to the market's return than the lousy stocks can subtract. This phenomenon is known as "skewness."
"That creates a situation where some real highfliers can lift the average above what the typical stock is doing," says David Ikenberry, a finance professor at Rice University in Houston.
That, indeed, has been the case almost every year. For proof, consider a study by Ikenberry and Indiana University's Richard Shockley and Dartmouth College's Kent Womack. They looked at the returns of the companies in the S&P 500 over the 34 years ended 1995.
In 31 of those 34 years, fewer than half of the stocks in the S&P 500 earned more than the average return for all stocks in the index, calculated on an equal-weighted basis. Because the top performers dragged the average up so much, the typical stock - those that rank in the middle in terms of annual gain - underperformed this average by some 4 percentage points a year.
"The skewness varies from year to year," Ikenberry notes. "This year, my sense is that it's extreme. But more subtly, you find this across the years."
The S&P 500 includes mostly large-company stocks. But Ikenberry says the problem isn't limited to these companies. Indeed, "skewness is more prevalent among smaller stocks," he says. Each year, "there is a handful of small stocks that just explode."
Still, the moaning about the market's narrowness tends to be loudest in years like 1998, when big stocks are doing relatively well.
"When people talk about narrowness, the context is a lot of money managers trailing the S&P 500," observes Meir Statman, a finance professor at Santa Clara University in California. It's tougher for managers to beat the index when the big companies that dominate the S&P 500 dazzle.
Just how tightly bunched are each year's stock-market profits? To get a handle on this question, Ibbotson Associates calculated how much lower the S&P 500's return would have been over the past dozen years if you excluded those 50 stocks that added the most to the index's gain.
The Chicago research firm looked at returns weighted by stock-market value, rather than weighting the 500 companies equally, as the three professors did for their study.
Ibbotson found that, without the 50 biggest winners, the index's annual gain would have been almost cut in half. In 1998's first six months, for instance, the S&P's total return would have dropped from some 17 percent to less than 7 percent, if you toss out the top 50 moneymakers.
In all this, there is a critical investment lesson for investors tempted to try to cherry-pick the best stocks in this otherwise dismal market. History suggests that the odds are heavily stacked against you and that you are more likely to end up hurting your returns than helping them.
"You're taking a huge risk," argues Robert Levitt, a financial planner in Boca Raton, Fla. "Will you be lucky enough to pick those one or two stocks that outperform? The more stocks you own in the portfolio, the greater the chance of picking those few dramatic outperformers."
Of course, the more you diversify, the less you will benefit if you do pick those big winners. But you will also suffer less if you pick badly.
"If you concentrate and you own a few stocks that fall out of bed, you can really be in trouble," Levitt says. "But if you diversify and one of those stocks tanks, it doesn't matter."