According to data from Howard Silverblatt, senior index analyst at S&P Dow Jones Indices, the top 7 companies were responsible for 75% of the S&P 500's gains in 2023. The "S&P7" valuations are beginning to look similar to the Nifty Fifty and the tech bubble in March 2000. There are signs of a bubble nestled within an index that in aggregate shows no cause for alarm.
Highlights
- Relying heavily on broad equity market index performance can lead to a skewed representation of market conditions
- Through end of October, the S&P500 is +10.69% on the year while the S&P 500 equal-weighted index is -2.36% on the year; a differential of more than 1,300 basis points
- Understanding the implications (and limitations) of market cap weighting can lead to a more optimal asset allocation plan
Beneath the surface of the widely followed S&P 500 Index lies a method of calculation that may lead to a misleading representation of the market's true dynamics. The culprit? Market capitalization weighting, a system that grants outsized influence to the largest stocks, potentially distorting the broader market picture.
Summary: High Market Capitalizations Impact Index Movements Most
The S&P 500 is a market-capitalization-weighted index, meaning that the companies with the highest market values have the greatest impact on the index's movements. In theory, this approach makes sense – larger companies typically represent a larger share of the economy and, therefore, should carry more weight in an index designed to reflect market conditions. However, this methodology has its drawbacks, particularly when it comes to assessing the overall health and diversity of the market (and your traditional equity portfolio).
One of the primary criticisms of market cap weighting is that it gives undue influence to a handful of mega-cap stocks. Take, for example, the technology giants like Apple, Amazon, Microsoft, and Alphabet. These companies, with their colossal market values, exert an outsized impact on the S&P 500. While they are undoubtedly influential, relying heavily on their performance can lead to a skewed representation of market conditions.
The dominance of mega-cap stocks introduces a phenomenon known as the "index effect." When these giants experience significant price movements, whether positive or negative, the entire S&P 500 is disproportionately affected. This can create a scenario where the performance of a few mega-cap stocks dictates the narrative of the entire market, potentially overshadowing the diverse array of smaller and mid-sized companies that constitute a significant portion of the index.
Participants Focus on High-Profile Companies and Overlook the Broader Market Landscape
Investors, relying on the S&P 500 as a benchmark, may inadvertently be swayed by the performance of a select few mega-cap stocks. This can lead to a form of "herd mentality," where market participants focus on high-profile companies and overlook the broader market landscape. Such a mindset can create bubbles and distort perceptions of risk and reward, as investors may be drawn to the momentum of a few large stocks rather than conducting a comprehensive analysis of the market as a whole.
One may invest in in an S&P 500 Index replication product or ETF and believe they are diversified. In a way, they are, they have exposure to 500 stocks. Diversification however is more than just the number of stocks and it's means (or at least should mean) more than the allocation to those 500 stocks. Even if one has equal exposure to 500 stocks, are they diversified if say 75% of the risk comes from 5 of those stocks and 75% of the return comes from a different set of 5 stocks?
A recent example of this comes from Apollo, who’s economist astutely highlighted “The divergence between the S&P7 and the S&P493 continues.” Also known as “The Magnificent Seven” (AMZN, AAPL, GOOGL, META, MSFT, NVDA, TSLA), these are among the largest cap stocks included in the index. Concerning is that their outperformance and possible entrance into bubble territory is masked by the other 493 stocks. Investors buying the S&P500 today are buying seven companies that are already up 80% this year and have an average P/E ratio above 50.
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The danger in this? The S&P7 valuations are beginning to look similar to the Nifty Fifty and the tech bubble in March 2000, see the second chart below, courtesy of Apollo. There are signs of a bubble nestled within an index that in aggregate shows no cause for alarm.
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As critics raise concerns about the potential pitfalls of market cap weighting, alternative weighting methodologies gain traction. Equal-weighted indices, for instance, assign an equal percentage to each component, mitigating the influence of mega-cap stocks. This approach provides a more balanced representation of market conditions, allowing smaller companies to contribute meaningfully to the index's performance.
Through end of October, the S&P500 is +10.69% on the year; the S&P 500 equal-weighted index is -2.36% on the year. This differential is more than 1,300 basis points. Yet an investor in each version of the index would considered themselves diversified. Not all diversification is the same.
Understanding the Implications of Market Cap Weighting; Obscuring Possible Bubbles and Leading to a False Sense of Diversification
While the S&P 500 remains a valuable tool for assessing overall market conditions, investors should approach it with a critical eye towards understanding the implications of market cap weighting. The disproportionate influence of mega-cap stocks can create a distorted view of market dynamics, potentially leading to misguided investment decisions. Exploring alternative indices and alternative investments and considering a more comprehensive analysis of market fundamentals can help investors navigate the complexities of the ever-evolving financial landscape. Most importantly, investors must consider the diversification of their return risk and return drivers, and not just their allocation amounts.
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