Stop Fighting SPY: How to Position While the S&P 500 Leads Everything

The S&P 500 has outperformed so consistently, it doesn’t matter whether it is skewed to a handful of stocks, or that it is historically expensive. So while market watchers (myself included) are mystified as to how the market can stay elevated like this, I realized a long time ago that this is not at all relevant. Because investing is about confronting and exploiting the markets we have, not the ones we think we should have.

For those newer to equity investing, there was a time when diversification mattered. Depending on the year, investment performance, not to mention asset flows from investors, would rotate between “headline” index ETFs like the first-ever ETF, the SPDR S&P 500 ETF Trust (SPY), the

SPDR Dow Jones Industrial Average ETF (DIA) which tracks the more tenured US stock market benchmark, iShares Russell 2000 ETF (IWM) which dominated for decades last century, and the iShares MSCI EAFE Index (EFA), which mostly covers Europe and Asia (with a portion invested in Australia).

S&P 500 vs. IWM, DIA and EFA — The Scoreboard

Today, however, and for several years now, it has been the S&P 500’s world. And we’re just living in it. Here’s a quick comparison table. EFA has made up for some lost time so far this year. But as we’ll see below, non-US stock markets have a long way to go to win back traders’ confidence. It might take a US Dollar decline of some magnitude to even start that conversation.

Why Small Caps Lag: Debt Loads and Refinancing Risk

The small cap index IWM has a pseudo excuse. It has gone from the best and brightest small cap stocks, to an index in which more than ⅓ of holdings are essentially beholden to the debt markets. They must refinance in order to stay afloat. That says a lot about how the same type of wealth disparity that has befallen the US population over time has also taken hold of the stock market.

SPY vs. other ETF benchmarks. Source: Barchart.

This graph shows the predicament more clearly, especially if one has been in the business of selling against US large cap stock investing over the past 10 years.

Rolling 3-Year Returns: A Self-Reinforcing Cycle

Rolling 3 year annualized returns. Source: Ycharts.

What we see above is a streak of consistent SPY outperformance over the past half decade over the other benchmarks. And while DIA had a decent relative run before the pandemic, since that time, the big tech stocks have out-earned and dominated the rest of the market.

How Traders Should Position While SPY Leads

What type of actionable steps can traders take? First, recognize that this is likely not simply a matter of past performance persisting. It is a self-fulfilling prophesy, since it occurred during a time of historic retail investor interest in stock investing.

Benchmarking Strategy — Treat SPY as Core, Not a Foe

This is a double-edged sword. Assuming SPY will continue to lead in good and bad markets is risking being on the wrong side of history. Because the stock market is notoriously cyclical.

However, traders should realize that turning the tide toward a more competitive equity market is not something that has to happen any time soon. Ultimately, the decision boils down to this, and it’s a very personal one: is the S&P 500 and SPY your own chosen benchmark? If so, past performance indicates that 40% years in either direction are possible. Think about that.

Bottom Line — Respect the Trend, Anticipate the Turn

And if SPY is not your benchmark, its popularity has reached the point where it cannot be ignored. That doesn’t mean you need to bet against it. But it will help to account at all times for the resilience it has shown. In particular, the “glamour” stocks at the top. It has reached the point where it is more understandable to own an S&P 500 index fund as a pseudo defensive measure, just in case it continues to be the “only game in town” as it has been, relatively speaking.

Asset allocation, globally and by market cap, still has a place. However, the proving ground is higher. As the late, great father of value investing Benjamin Graham said, in the short-term the stock market is a voting machine. In the long-term, it is a weighing machine. Until something shakes up this market for more than a few months at a time, the incumbent S&P 500 is still the one to beat.