The S&P 500 and the Nasdaq Composite are enjoying bull markets, but investors shouldn’t get caught sleeping. The recent gains have come in a somewhat unusual way and could have major ramifications for performance over the next year or two. Consider this trend and its implications, and make sure your investment allocation makes sense in that context.
How to define “the market”
The S&P 500’s performance is often considered synonymous with the overall stock market’s performance. Other major indexes, such as the Dow Jones Industrial, provide a slightly different view based on sector and industry.
If these indexes are all up, it’s generally fair to assume that the market, as a whole, would be doing well. Some stocks will struggle during any long periods, but gains elsewhere will more than offset those losses when indexes rise.
Over the past 12 months, the S&P 500 has returned 33.5%, while the Nasdaq is up 42.3%. It’s tempting to see that information and conclude that there’s been broad strength in corporate financial performance and surging investor sentiment. That’s a mostly fair assessment. Average sales and earnings are growing among S&P 500 constituents, and investor sentiment is relatively bullish.
On the surface, everything seems positive, but there’s an uncommon trend bubbling beneath the headline data. It might be consequential for investors who ignore it.
Not all boats are rising with the tide
Most indexes are weighted by market capitalization. That means that stocks with higher valuations make up larger proportions of any index. That methodology makes sense — the biggest companies have outsized impacts on overall economic activity and shareholder results, so index weighting should reflect that.
That leads to a significant concentration in market indexes. The 50 largest companies in the S&P account for nearly 60% of the index. Microsoft is 7% of the S&P on its own. A small number of stocks are exerting significant influence over most measurements of total market performance.
Alternatively, some exchange-traded funds (ETFs) are equal-weighted, so company size and valuation have no bearing on portfolio allocation. Each stock held by these funds will contribute equally to overall performance.
By tracking the performance of equal-weighted funds, you can determine whether smaller stocks are sharing in the total market’s performance. Comparing the performance of equal-weighted funds to market-weighted indexes is illuminating, especially if something unusual is happening. And that’s exactly what’s going on right now.
The Invesco S&P 500 Equal Weight ETF (NYSEMKT: RSP) has lagged the S&P 500 index by nearly 14 percentage points over the past year. There’s a similar gap between the Direxion NASDAQ-100 Equal Weighted ETF (NYSEMKT: QQQE) and the Nasdaq.
The equal-weighted funds performed well over the past year. Those are above-average rates of return, but it’s clear that most stocks aren’t thriving to the same extent as the largest ones. If you just look at index performance, there’s no way to recognize this fact.
There could be a number of reasons for that performance gap, but there’s a good chance that the recent divergence isn’t sustainable. If that’s the case, there are serious ramifications for the stock market over the next couple of years.
The “Magnificent Seven”
History suggests that the biggest stocks don’t stray too far from the rest of the market over the long term. Some of the tech giants have enjoyed strong momentum during recent bull markets, but equal-weight ETFs have tended to keep pace with their cap-weighted cousins.
Something changed over the past year. The “Magnificent Seven” is a group of tech stocks that have dominated the market recently.
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Microsoft
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Apple (NASDAQ: AAPL)
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Amazon (NASDAQ: AMZN)
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Tesla (NASDAQ: TSLA)
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Alphabet (NASDAQ: GOOGL)
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Nvidia (NASDAQ: NVDA)
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Meta (NASDAQ: META)
These companies are considered leaders in relatively high-growth industries, and many of them impressed investors by slashing costs during uncertain economic conditions last year. Widespread concerns about consumer strength and high interest rates kept investors from going all-in on riskier growth stocks. They were concerned that if the economy dipped into recession, volatility would likely wipe out shareholder value.
However, the prospect of upcoming rate cuts by the Federal Reserve made asset managers hesitant to allocate too conservatively. The Magnificent Seven offer a rare combination of reliability and above-average growth potential. This attracted a lot of capital last year, with hedge funds and retailers buying up these stocks during the opening stages of the artificial intelligence (AI) craze.
These companies have been posting encouraging financial results, but their surging prices were driven, at least in part, by valuation inflation. Most of that group became significantly more expensive relative to sales and forecast earnings.
The Magnificent Seven now trade at premium valuations. Unless they continue to deliver financial results that significantly outpace the rest of the market, valuations will likely move back toward more of an equilibrium, based on future cash flow. If that happens, these high-flying tech giants might see bigger losses in the next market correction, or the rest of the index may close the gap throughout this bull market.
That’s why it’s so important for investors to monitor their portfolio concentration and avoid getting too greedy. There are a lot of great stocks available on the market. It’s OK to ride with some high-conviction stocks, but it’s wise to rebalance your portfolio periodically when relative valuations change. Don’t abandon your long-term investment thesis, but recognize that last year’s winners won’t necessarily be this year’s winners.
It doesn’t matter whether you’re an index investor or holding some of these stocks individually. Make sure that your expectations reflect the context of recent performance.
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1 Hidden Trend Has Dominated the Stock Market but Can’t Last Forever. Here’s How You Can Keep Your Portfolio Safe. was originally published by The Motley Fool