The Nasdaq to S&P 500 ratio is a financial metric that compares the performance of the Nasdaq Composite Index, which primarily consists of technology and growth-oriented companies, to the broader U.S. stock market represented by the S&P 500. When the ratio rises, it indicates that the Nasdaq is outperforming the S&P 500, suggesting that technology and growth stocks are experiencing stronger growth and generating higher returns compared to other sectors represented in the S&P 500. Conversely, when the ratio falls, it implies that the Nasdaq is underperforming the broader market, indicating relative weakness in the technology and growth sectors compared to other industries.
By definition, this ratio cannot grow forever. At some point, the stocks listed on the Nasdaq Exchange would simply make up 100% of the US stock market.
Historically, the ratio reached its peak during the Dot-com mania in the year 2000. This period was marked by an excessive optimism and overvaluation of technology companies, particularly those listed on the Nasdaq exchange.
The Nasdaq Composite tracks the performance of all common equities listed on the Nasdaq stock market exchange.
The S&P 500 consists of 500 large US companies and captures approximately 80% of available market capitalization. Therefore, it is quite representative of the overall US stock market and moves almost identically to the Wilshire 5000.
Both indices are capitalization-weighted and do not include dividends.
The chart above displays the 1-year rolling correlation coefficient between the Nasdaq Composite and the S&P 500. A correlation coefficient of +1 indicates a perfect positive correlation, meaning that the two indices moved in the same direction during the specified time window. Conversely, a correlation coefficient of -1 indicates that they moved in opposite directions. The chart shows that the correlation between the Nasdaq and the S&P 500 tends to be positive. The correlation coefficient is important for diversification because it helps investors assess the potential benefits of including both the Nasdaq and the S&P 500 in their investment portfolios.
Diversification is the practice of spreading investments across different asset classes to reduce risk. In his book Principles, Ray Dalio called diversification the “Holy Grail of Investing”. He realized that with fifteen to twenty uncorrelated return streams, he could dramatically reduce the risks without reducing the expected returns.
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