This Is the Scariest Chart for Index Investors – Waco Tribune-Herald

This Is the Scariest Chart for Index Investors

Index investing has changed over the past two years, and it might be losing some of its benefits. The concentration of the stocks that make up the major stock indexes is different than it’s been at any point in history. This impacts volatility, valuation, and dividend yields, and index investors really need to understand what that means for their portfolios.

A major shift

The market’s been on a phenomenal run since the COVID-19 collapse in early 2020. It has erased those losses and then some, charging to all-time highs and historically high valuation ratios. The stars of this rally have been mega-cap and large-cap tech stocks.

In the past, the oil stocks and consumer staples were mainstays among the largest S&P 500 constituents. Not anymore.

Today’s ten largest stocks in the large-cap index include six tech stocks, a conglomerate, a bank, a health insurance plan provider, and Tesla, which is a consumer cyclical stock that behaves a lot like a tech company.

The five most-valuable companies are Apple, Microsoft, Alphabet, Amazon, and Meta Platforms. Overall, tech is more than one-third of the S&P 500.

Never before has the technology sector had such a large influence on the total market, even going back to the dot-com bubble.

It’s not just sector concentration, either. The above five tech giants make up nearly 20% of the value of the entire market. The ten largest stocks now account for more than a quarter of the total market and nearly 35% of the S&P 500. They also contribute a similar amount of the large-cap index’s total profits.

People often talk about “the market,” which is a decent way to judge the status of most stocks. However, major indexes aren’t quite capturing the performance of smaller large-cap stocks at the moment. There’s always been concentration at the top, but it hasn’t been nearly this pronounced at any point in recent history.

Image source: Getty Images

Implications for index investors

There are pros and cons to this development, and index investors should be aware of them.

Indexing has traditionally been a good way to diversify and bet on the economy as a whole. If the U.S. and global economy keep expanding, then the big companies that provide goods and services will naturally grow along with that. There are bound to be some winners and losers, but overall, the trend should be positive. This diversified approach means no single company can derail your investment performance, even if there’s significant concentration at the top.

That math has obviously changed. Individual companies now carry much more influence. Moreover, the threat of correlation is also relevant. Mega-cap tech stocks each have their own core business that they’ve come to dominate, but they also overlap in many ways. The same macroeconomic, social, or competitive forces can influence multiple market-driving stocks at the same time. That further reduces the diversification provided by index funds, which is supposed to be their strong suit.

Index investors’ risk and growth profiles have also been drastically altered. Several of these massive companies are growing close to 20% annually, and a couple are expanding even faster than that. Growth is great, but there’s more to the story.

Valuations have become much more aggressive in the market, too. The average forward price-to-earnings ratio (PE) for the full S&P 500 is around 22, and it’s one of the higher levels in recent history. The average forward PE for the ten largest stocks is above 40, so that’s a key factor behind the valuation increase.

These aren’t your industrial, conglomerate, and manufacturing giants of the old days. High growth, innovative tech stocks attract premium pricing, even if they’re already enormous. Higher valuations also tend to create more volatility. Market corrections might be more extreme now.

Dividend investors also need to take notice. The S&P 500 average dividend yield was around 3% for decades, and it has generally hung around 2% since the turn of the century. It’s down to 1.26% right now.

Some of that is due to the low yields across capital markets in general, but it’s also caused by the influence of stocks that pay zero or very small dividends. These big tech stocks are still investing cash into growth rather than distributing it to shareholders. If you’re a retiree or someone who just likes the stability of dividend investments, then index funds have evolved into something far less appealing for you.

If you bought an index fund five or ten years ago, and your investment goals and risk tolerance haven’t changed, then it actually might no longer perfectly match your criteria. That’s not something we’ve had to consider with passive index strategies. That’s not to say the strategy isn’t valid anymore — a lot of the logic still applies. Still, it might be time to review your investment plan to ensure that an active strategy hasn’t become more suitable.

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Suzanne Frey, an executive at Alphabet, is a member of The Motley Fool’s board of directors. Teresa Kersten, an employee of LinkedIn, a Microsoft subsidiary, is a member of The Motley Fool’s board of directors. Randi Zuckerberg, a former director of market development and spokeswoman for Facebook and sister to Meta Platforms CEO Mark Zuckerberg, is a member of The Motley Fool’s board of directors. John Mackey, CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool’s board of directors. Ryan Downie owns Alphabet (A shares), Amazon, and Microsoft. The Motley Fool owns and recommends Alphabet (A shares), Alphabet (C shares), Amazon, Apple, Meta Platforms, Inc., Microsoft, and Tesla. The Motley Fool recommends the following options: long January 2022 $1,920 calls on Amazon, long March 2023 $120 calls on Apple, short January 2022 $1,940 calls on Amazon, and short March 2023 $130 calls on Apple. The Motley Fool has a disclosure policy.

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