Investing in 500 stocks sounds like diversification. If one goes down, the other 499 perseveres. This is not exactly the way the S&P 500 works.
The index is weighed by capitalization which is defined as the price per share times the number of shares outstanding. This results in larger companies making up a larger share or weight of the index than smaller companies. On the surface this seems fair. After all, who wants an index driven by the smallest companies?
The problem comes when the largest companies become so large as to make a mockery of the index. Last month it was pointed out that ten of the largest companies made up 37 percent of the index. Another way to look at it: The S&P index is divided into eleven industry groups. One group, technology, makes up 40 percent of the value of the index. In effect, investing in the index is a 40 percent bet on technology. The other ten sectors make up 6 percent apiece on average.
While this concentration is a record, it is not an anomaly. In 2000, at the height of the dot-com bubble, tech represented 32 percent of the index. A year later that concentration fell to 18 percent. It stayed in the range of 15-19 percent for almost twenty years. In the early 1970s energy became almost 35 percent of the index before declining to 6 percent later that decade as oil prices rose and fell.
In essence, history teaches us that we have seen this movie before. The difference this time is how many people are invested in broad indexes due to the rise of passive investing. Originally, passive index investing was championed by those who felt that fees and transaction costs made active investing a riskier and more expensive approach. Now, passive investing has become so massive that its inflows and outflows are dictating the market as opposed to active investment management.
This is witnessed by the gaps between the closing price of a stock one day and the next. When there is a material decline or increase of more than a few percent in a stock’s price in a single day, it often means that there is no liquidity in that part of the market. There is no one on the other side of the trade to buy from or sell to. The stock lurches upwards or downwards until someone on the other side is found to make a transaction.
Benjamin Graham, “father of value investing, “spoke of these situations as buying or selling opportunities. Graham was addressing the contex of a single stock, not an index of 500 stocks. Graham believed that markets were prone to mispricing securities and an informed investor could take advantage of such. An index allows no such advantage, as an investor is buying the entire lot in proportion to each factor, weighed by size. At any one time there are stocks that are overvalued, just as there are stocks that are undervalued. When you buy an index, you buy them all. Such a position does not faze a believer in efficient markets. For the rest of us, it is an opportunity and a challenge.
Of the eleven sectors of the S&P 500, some are overvalued while others are not. For smaller amounts of money, sector funds offer some approach to the current market turmoil if sectors are studied for their potential and valuation.
For larger portfolios, individual issues can be combined to represent the undervalued sectors. In effect, a larger stock portfolio is a fund with only one participant.
While the size of an individual portfolio varies with the manager, 12-20 stocks should be sufficient. Beyond this is closet indexing, a habit of managers who have a fear of missing out in the short run. A portfolio or fund of 100-200 stocks does not represent conviction so much as mediocracy.
As of this writing, the index of volatility, or VIX, is about twice as high as it was a week ago. Such would suggest that there is more turbulence ahead. The best approach is to know what you are invested in and have some faith in the same. The future is always uncertain. Since everyone cannot be right all the time, it behooves one to be apart from the crowd. Not everyone can buy when others are selling.
As for valuations: with a growth sector like technology there are always those who contend that they hold the keys to the future. The challenge is to accurately value that future and choose the beneficiaries. People do not buy technology. They buy what technology will do. The applications of technology increase as its cost declines. Thus, the Faustian bargain of technology is one of expanding unit demand offsetting declining price. If price declines faster than unit demand increases, revenues stagnate, and then the stocks fall back to earth.
The Economy
A lower-than-expected jobs growth number for July and an uptick in the unemployment rate set off a panic in stocks that a recession may be at hand. In reality, both
slowing jobs and higher unemployment are necessary to get inflation back closer to 2 percent. Given this fact, the developments should not have been unexpected or adverse in terms of prices had the market been fairly valued from the start. So much for efficient markets.
The Goldilocks economy in which both inflation and economic growth are at lower levels is being orchestrated. For a market that was worried about inflation, this should have been a positive thing. However, as the economy slows and companies like McDonalds report its first quarterly revenue decline since covid, people are beginning to realize that low inflation will also mean slower growth. They are two sides of the same coin.
Inflation
Inflation is down, but not to the 2 percent level that was supposed to be the signal for the Federal Reserve to begin easing interest rates. Still, given the Fed’s dual (and contradictory) mandate of low inflation and full employment, it is expected that the Fed will reduce interest rates in September. They may reduce interest rates prior to that date. In effect, they will declare victory and go home.
Interest Rates
In response to the perceived poor news about employment, debt instruments have rallied, and interest rates have declined significantly in the process. The ten-year rate is below 4 percent in anticipation of the Fed rate cuts believed to be set to begin in September. The interest rate parlor game now revolves around whether there will be two or three reductions in 2024.
The backdrop for lower interest rates in the future (i.e. 2025 and beyond) is not good at present. The Federal government continues to spend more than it takes in. The debt ceiling will soon be up for discussion and debate with the ensuing brinkmanship over shutting down the government. For this and other reasons it is assumed that interest rates will reverse and ratchet up over time. The idea that rates will go back down to pre-covid levels is at best a dream. Only meaningful tax increases will change this scenario. That is outside the Fed’s control. Tax changes are the domain of congress.
The Stock Market
After skating along on, first low interest rates, then the covid stimulus and now the AI craze, it would appear that some parts of the market are in need of a revaluation.
The technical name for a change in favored stock sectors is rotation. Usually during a rotation, the overall indexes churn up or down while different parts of the market act in a more or less exaggerated manner.
While new market sector leadership has not yet been designated, it should be noted that historically, the chance of the same sector leading the market two consecutive times is less than one in five. Some people who have invested in the leaders of the past cycle and who want to wait for their prices to recover before selling may have a long wait.
Parenthetically, the reputation of international investing has taken another hit. It seems that foreign markets are declining faster than the US. So much for asset class
diversification creating portfolio stability. Partnership investments are at present not being revalued, mainly because they cannot be sold. Their portfolio stability is at best illusory, at worst misleading.
Warren M. Barnett, CFA
August 6, 2024
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