New York (CNN Business)Thousands of stocks trade on Wall Street every day. But let’s be honest: Just a half dozen companies really, truly matter for many investors.
Following the addition of Tesla (TSLA) to the S&P 500 last month, Elon Musk’s electric car giant joins a quintet of tech stocks that dominate the blue chip index.
Apple (AAPL), Microsoft (MSFT), Amazon (AMZN), Google owner Alphabet (GOOGL), Facebook (FB) and Tesla are now collectively worth more than $8.1 trillion, accounting for nearly 25% of the total $33.3 trillion market value of all the companies in the S&P 500.
Given the popularity of passively managed index funds — more than 70 million shares of the SPDR S&P 500 ETF (SPY) change hands daily on average — this means many investors that buy an S&P 500 fund for diversification purposes are really getting a highly concentrated tech sector fund.
That could be a problem for investors who want to minimize risk, especially since Tesla is far from being a mature and stable company.
“Tesla just completed its fifth quarter of profitability, sells significantly less cars than its auto maker peers, and continues to actively access capital markets to fund operations,” said Lindsey Bell, chief investment strategist with Ally Invest, in a report just before Tesla joined the S&P 500 last month.
“This along with the stock’s volatile nature will have implications for the broad index near-term,” she added.
Broader market gains influenced by small number of stocks
Sure, the exposure to top tech firms didn’t hurt investors last year. The overall S&P 500 finished 2020 up 16% — thanks to the fact that the index is market-cap weighted.
But tech stocks could come under increased pressure following the Georgia Senate races.
The projected victory for Raphael Warnock and current lead for Jon Ossoff could give Democrats control of the Senate. (It would be a 50-50 split with Vice President-elect Kamala Harris getting the tie-breaking vote.
The Nasdaq fell Wednesday morning as investors worried that the incoming Joe Biden administration and emboldened Democrats in Congress will enact tougher regulations on big tech companies and potentially pursue further antitrust reviews.
The strength of the S&P’s Big Six also hides the fact that the rest of the market isn’t doing nearly as well. If you weighted all the companies in the S&P 500 equally last year, the S&P 500 (RSP) rose just 10%. That’s still respectable of course but not nearly as good as 16%, obviously.
“This is a concern. Tesla is exacerbating the overweighting of tech stocks. They have driven the gains for the market inordinately,” said George Calhoun, professor of quantitative finance at the Stevens Institute of Technology, in an interview with CNN Business.
Last year, 200 of the S&P 500 companies finished 2020 in the red. So it was a much tougher year for the overall market than the headline numbers would indicate.
Some veteran market experts worry that the frothy levels for stocks that are leading the market are unsustainable. We’ve seen this movie before. It won’t end well.
“The long, long bull market since 2009 has finally matured into a fully-fledged epic bubble,” said Jeremy Grantham, co-founder of investment firm GMO, in a report this week.
“Featuring extreme overvaluation, explosive price increases, frenzied issuance, and hysterically speculative investor behavior, I believe this event will be recorded as one of the great bubbles of financial history,” Grantham added, comparing it to the crashes of 1929 and 2000.
Grantham pointed out that good companies don’t necessarily make for smart investments. He even noted that he owns a Model 3 but still thinks Tesla’s stock is an example of a “mania” and “really crazy investor behavior” and that it is drastically overvalued when compared to rivals like GM (GM).
History repeating itself may not be a problem?
Still, some strategists argue that investors shouldn’t be worried by the fact that the market is being led by such a small group of stocks.
“This isn’t unprecedented. The concentration in one sector is higher but it’s been this high in the past,” said Ryan Giannotto, director of research at GraniteShares, referring to times when oil stocks, industrial firms and banks dominated the S&P 500.
Why tech stocks are soaring after Election Day
“It all depends on where the earnings growth is and what’s expected to happen with the economy,” he told CNN Business.
Giannotto even argued that it’s a bad move for investors to hold equally sized positions in a larger number of stocks because that means they’d be stuck with more dogs in their portfolio and wouldn’t benefit as much from the big gains of the best performers.
“An equal weighted strategy is risky. The problem is you are buying more of the companies that are getting left behind instead of minimizing the laggards,” he said.
That said, many of these losers could eventually become the market’s new leaders — which is all the more reason for investors to have a diversified portfolio instead of making bold, concentrated bets.
“I’m not predicting a crash but you can certainly make the case that there needs to be a rotation away from tech and back more towards value stocks that have underperformed,” said Stevens Institute of Technology’s Calhoun.
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