Stock Market Halitosis

One could be forgiven for thinking a stock market index is a broadly diversified basket considering that the number of stocks is literally in its name: The S&P 500. Many mistakenly believe that if they invested $500 in the S&P 500, roughly $1 would go into each of the underlying stocks. However, what they don’t realize is that the index is market-cap weighted, not equally weighted. This means the largest companies by market capitalization (what they are worth in their entirety) have a disproportionate influence over the index’s returns, either good or bad.

At the time of writing, Whirlpool was the 500th company on the list, and its weighting in the index was 0.01%. What are we talking about here in real terms? Let’s say you have $500 invested in the S&P 500. In that case, a 0.01% weighting gives you only five cents invested in Whirlpool – a de minimis amount, to be sure. If Whirlpool’s stock suddenly doubled in value, you would have 10 cents – big whoop. So, in reality, the stocks on the low end of the S&P 500 Index don’t move the needle much.

Let’s now consider the impact of the so-called “Magnificent Seven,” a group of very large technology stocks that currently represent a disproportionate percentage of the S&P 500 Index. This group is comprised of Alphabet (formerly Google), Amazon, Apple, Meta (formerly Facebook), Microsoft, Nvidia, and Tesla.

Collectively, these seven stocks account for over 29% of the S&P 500 Index value weighting. Let’s do the same math we did for Whirlpool and see where we come out. If you invest $500 in the S&P 500 Index, how many dollars will be allocated to these stocks? $146.05! In other words, as these stocks go, so goes the index – for good or bad. Recently, it has been for good. Fueled primarily by the artificial intelligence (AI) boom, these technology stocks rallied hard last year and so far this year. In fact, Nvidia, which alone accounts for 4.34% of the S&P 500’s weighting, is up 50% for the year at the time of writing.

What is the lesson here? In a very real sense, the current market has bad breadth, meaning the advancing issues – the number of stocks achieving new highs – rest in an ever-smaller number of companies. In contrast, a healthy stock market has a large number of companies from various sectors of the economy all achieving new highs; it exhibits good breadth.

Right now, we do not have good breadth, yet to the untrained eye, the market – as represented by the S&P 500 Index – seems to be doing just fine. In fact, it is up 5.59% year to date. However, when you pop the hood to see how this market engine is working, you quickly realize that most of the return is coming from a handful of tech companies in the index. These happen to be the names with the most weight within the S&P 500. When things are going great, this works very well, as is the case right now.

What happens if the tech sector takes a breather (at the risk of over-playing the pun, I’m sticking with my halitosisinspired analogy)? Worse yet, what if technology stocks see a significant retracement of value? Can’t happen, you say? Speaking as someone who has been in this industry long enough to witness many market cycles, I direct your attention to Exhibit A: the tech wreck of 2000.

Between 1995 and 1999, the S&P 500 enjoyed four back to- back years of significant double-digit gains, driven primarily by the euphoric promise of the benefits worldwide internet access could deliver to global society. Was the internet a revolutionary invention? Absolutely! Did it change the way commerce was done? Yes! Did that mean the valuation of internet stocks could continue to grow with reckless abandon? Nope! At some point, valuations mattered again. Ultimately, the value of a company’s stock had to re-calibrate to the appropriate level of earnings it could produce for investors. Trees don’t grow ad infinitum. (Sorry, but someone had to say it.)

As a result, a comeuppance of biblical proportions started in March of 2000 and didn’t relent until the end of 2002 – three negative years in a row that resulted in a cumulative 46% decline in the value of the S&P 500 Index. By the way, the tech sector’s weighting in the S&P 500 just prior to this decline was a whopping 35%! When you compare this with the current 29%, you can see that tech valuations appear to be getting overstretched again. For those who have seen this movie before, the parallels between today’s AI-fueled tech stock rally and yesteryear’s internet craze are simply too numerous to miss.

So, what is a prudent investor to do? I would recommend talking to your Summit advisor about how to properly position your portfolio based on your risk tolerance and outlook for the market. Our quiver has many arrows that can be used to mitigate portfolio risk! Worried about market halitosis? We’ve got a pocket full of Tic Tacs, and we’re willing to share. All you have to do is ask!

-Jeff Janson, CFP®, AIFA®, CBDA

Senior Wealth Advisor