The index is “concentrating” … should you leave it alone?
I must admit, with all that I write about the S&P 500 Index, it looks weird to see it without the last zero, as it is in the title of this article. But that is not as weird as the sustained predicament with that index regarding its “concentration.” That is, the index which holds approximately 500 stocks is essentially ignoring half of them. You see, the S&P 500 is like many indexes (and thus the ETFs and mutual funds that track them) in that its holdings are allocated by the size of the stock (“market capitalization”). That means that as big companies get bigger, as the market as a whole
moves higher, and as a few high-flyers emerge into “hot stocks,” the S&P 500 becomes far less democratic.
In fact, the longer this goes on, more stocks in the index become irrelevant to the index’s performance. This is not a problem…until it is. While the pressure of concentration builds, a few things happen: Investors get more confident that “owning the market” is the way to go…even though they own less of it than they think they do. More and more money chases the same small number of securities, which can potentially boost their valuations to nosebleed levels. The ultimate unwinding process (as this situation eventually reverses) gets more risky. Excellent opportunities outside of the concentrated segment of the S&P 500 are either ignored or are relegated to being “tactical” situations only. That is, market sectors or themes that are not prominently represented in the 50 largest stocks that make up about half of the S&P 500 may have their moments, but their prices don’t get the massive, sustained push higher that occurs with the “popular” stocks at the top of the index.
I think all of these situations are present in today’s market. But so, what? Until the air is let out of the bubble, prices can still go higher and higher. In fact, the possibility of an S&P 500 “melt-up” is growing, following a temporary shock to the system last December. In the year 2000, this was exactly what happened for the first 9 weeks of the year. And then, subtly, the concentration-led market rally topped, faded, and then plunged.Related: Long-Term Investors: The S&P 500 Is Not Your Friend. Here’s Why.
Are there imminent signs of that? Not really. And with markets being flipped around by news and algorithmic trading, and global debt and recession potential being shrugged off with ease, who knows how extended things can get?As the table above shows (focus on the blue rectangles, please), only 10 stocks make up the top 20% of the S&P 500. The next 15 stocks get that figure to 26%, and the top 50 are about 50% of the index. As for the other 450 stocks? They combine to have as much impact as the top 50. That’s concentration.