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Volume 10, Edition 39 | November 8 - November 12, 2021

Mind the Megacaps

Doug Walters, CFA
The advent of trillion-dollar companies has created some concentration risk in common indexes like the S&P 500. There are better ways to seek diversified exposure to equities.

Contributed by Doug Walters, Max Berkovich

The US stock market did not end up in positive territory this week, but it is still hovering near an all-time high. Yet cracks have formed in some market segments that should serve as a warning sign to anyone not being thoughtful about the risks in their portfolios. Even broad market indexes, like the S&P 500, may not offer investors the diversification they once did.

There was a time when the S&P 500 was a well-diversified index. Billionaire investor Warren Buffett is famous for stating that 90% of his wife’s fortune will be invested in a low-cost S&P 500 index fund when he dies. Yet, in recent years, the S&P 500 has developed a bit of a problem. You see, it is what we call a market-cap weighted index, meaning the 500 companies in the index are weighted based on their respective market capitalizations. So, an enormous company like Microsoft is around 6% of the index, while a smaller company like Nike is just 0.5%. The advent of mega-cap companies in recent years, with trillion-dollar valuations, has created some material concentration risk the index. In fact, the top six companies (Microsoft, Apple, Alphabet, Amazon, Tesla, and Meta Platforms) comprise over 25% of the index.

These mega-caps have done well the past year and a half as consumers use their technologies to overcome the many challenges that the pandemic posed. Other companies have also benefited, including Zoom and Peloton. But these latter pandemic winners have been stock market laggards in 2021. While we do not know what the future holds, we do know risk when we see it, and right now, market-cap-weighted indexes pose an unnecessary risk for those seeking diversification.

So how is an investor to navigate index concentration risk? One option is to use equal-weight indexes, which own each security equally. Historically, these indexes have tended to outperform market-cap-weighted indexes (which makes you wonder why the latter is more popular??). As evidence-based investors, our preference is “multifactor indexes”, which weight holdings based on fundamentals that have historically driven outperformance. None of these options would insulate an investor from a broad pullback in equities, but we believe they provide a much better flavor of diversification.

4.6%

Core CPI Inflation

Headlines this week were making a big deal that inflation is the highest since the early ’80s. While true, what matters more than the level is how long it lasts.

Headlines This Week

Stocks slipped this week after hitting all-time highs on Monday. Inflation was the driver of sentiment, with both the Producer Price Index (PPI) and Consumer Price Index (CPI) report coming in higher than expected.

Coming in Hot

Both readings for inflation this week, PPI and CPI, surprised to the upside, raising concerns that higher prices may be with us longer than expected.

  • Core CPI, which is the most directly relevant for consumers, is up 4.6% year on year, compared to predictions of 4.3%. Headlines were flagging that this is the highest inflation since the early ’80s. This is true, but the question is how long it will linger. The Fed is still forecasting a moderation of inflation to more comfortable levels next year.
  • Stocks were generally not excited about this data, particularly growth stocks, which had a tough week. Higher than expected inflation raises concerns that the Fed may need to act more quickly in raising rates. Growth stocks have been an outsized benefactor of lower rates, and therefore it makes sense that they would show some weakness on this news.
  • The bond market also saw big moves this week despite being closed for Veteran’s Day. Yields rose (prices fell) on the inflation news and concerns about higher rates sooner.

An Electric Market

Despite the muted equity performance this week, a big IPO reminded investors that we are still in a frothy market.

  • Soon-to-be car maker Rivian went public this week with a market cap that bested both GM and Ford, despite having negligible sales to date.
  • Competitor Tesla was also in the news as their shares have fallen 16% from a recent peek following comments that Elon Musk was considering selling some shares. Despite selling far fewer cars, the company has a $1 trillion valuation, dwarfing GM and Ford.

The Week Ahead

Economic Check In

As it was inflation’s turn last week that took the headline, next Tuesday, the market will be looking at the country’s retail sales numbers for insight.

  • Retails sales for October are expected to come in at 0.7% growth month-over-month, the same as for September.
  • A deviation to the downside could give concern to the markets and the Fed that the economy does not have the momentum it appears to have.

International Inflation

Several countries will be out with their inflation numbers next week, including Canada, the United Kingdom, and the Eurozone.

  • First up will be Canada and the UK on Wednesday to release their consumer price index (CPI) numbers.
  • Canada’s CPI reached an 18-year high of 4.4% in September and is expected to remain around that level, leading the market to expect an interest rate hike as soon as March of next year.
  • Expectations are for the UK’s CPI to hit 3.9%, well above the Bank of England’s limit of 3%.
  • Rising inflation in Britain has led the market to start pricing in a likely rate hike next month.
  • On Thursday, the Eurozone will be out with their CPI reading which hit 4.1% last month.

Nomination Incoming?

President Biden has stated that he intends to announce his nominees to the Federal Reserve Board as soon as next week.

  • The market expects Chairman Powell to be renominated for another four-year term as his current stint will expire next February.
  • In addition to the head posting, there are another three vacant positions to be filled, including the recently vacated vice chair of supervision which serves as the nation’s top banking regulator.

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