Morningstar - Q3 2020 - 9

EXHIBIT 1

EXHIBIT 2

Year-to-Date Returns Have Diverged for U.S. Large Growth, Small Value

Tech Giants' Share of the S&P 500 Is
More Than 20%

S&P 500
Nasdaq

Morningstar US Large Growth
Morningstar US Small Value

FAMAG Share of S&P 500

Morningstar Global Markets ex-US

25%

$120
102.30

21.6

100.84 100
15.2

88.95
79.60 80
9.5
62.65

10.3

15.5

20
15

12.1
10

5
0

40
01/2020

02/2020

03/2020

04/2020

05/2020

07/2020

Source: Morningstar Direct. Data as of 06/30/2020.

has well outpaced international stocks,
represented by the Morningstar Global Markets
ex-US Index.
Also, the S&P 500 itself is an agglomeration
of other markets, one that changes over time. The
composition of the S&P 500 has become
increasingly dominated by companies that
are doing well in the current environment because
they benefit from work-from-home consumers
or are Internet-related, have strong balance sheets,
have globally diversified revenue, or are defensive
by nature (meaning demand for their products
depends less on the strength of the economy).
Most other stocks are down, some by a lot. While
it feels like some parts of the market are doing too
well, other parts are pricing in negative outcomes
for energy companies and banks and outright
disaster for airlines, hotels, and cruise lines.
The Flaw of Averages

This is another example of "the flaw of averages."
When you add market-cap-weighting-
or the fact that larger companies make up more of
the total worth of a market-it's the flaw
of averages on steroids.
The flaw of averages is illustrated by the man who
sticks his feet in the freezer and his head in
the oven so he can feel comfortable, on average.

2015

2016

2017

2018

2019

2020

Source: Morningstar Direct. Combined share of Facebook, Amazon.com,
Microsoft, Apple, and Alphabet (Google) in the S&P 500 as of June 30 of
each year shown.

To give you a sense of the oven in the U.S. stock
market, EXHIB IT 2 shows the weighting in the
S&P 500 of five Big Tech stocks: Facebook FB,
Amazon.com AMZN, Microsoft MSFT, Apple AAPL,
and Alphabet GOOG. All these firms benefit from
the positives being rewarded by today's markets-
they are Internet-based and global businesses that
benefit from the work-from-home environment,
and they have strong balance sheets. Even though
they're technology stocks, not defensives,
investors aren't treating them as cyclical stocks.

For those businesses whose stock prices are
higher than they were at the end of January, one
has to wonder whether this environment should
call for higher valuations. Mark us as skeptical, but
there are still select opportunities.
We find those opportunities through our valuationdriven investment approach. Our valuation
research leads to calculations of the returns we
think an asset class will experience over
each of the next 10 years, averaged and adjusted
for inflation.

What Does This Mean for Portfolios?

While we will never have a satisfactory answer to
the question of what is driving the market,
we do think one can respond to the prices and
opportunities presented.
The market is facing a wide range of possible
economic outcomes with more uncertainty than
usual. In the wisdom-of-the-crowd model,
accuracy is driven by the diversity and accuracy of
individuals' guesses. We don't see anything
to suggest a greater diversity among guessers,
and most investors would say their guesses
have a wider range than normal, so the average
accuracy may be much lower than normal.
This means the market's accuracy may be hindered,
and the crowd's wisdom may have lost a few IQ
points. We think it could also mean opportunity for
investors willing to be different from the crowd.

U.S. small-cap value stocks are poised for much
higher returns-according to our valuation-based,
forward-looking return estimates-than U.S.
large-cap growth stocks. We see similar gaps
between U.S. and international stocks and among
sectors, with the energy and financials sectors
priced for the best returns.

In our opinion, market-timing is not possible;
however, we think the returns for value,
international, and energy stocks in U.S. dollars at
current prices look attractive for a long-term
U.S. investor. K
Daniel Needham, CFA, is president and chief investment
officer of Morningstar Investment Management. He is
a member of the editorial board of Morningstar magazine.

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Morningstar - Q3 2020

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