Equally Bad?
FOR YEARS, THERE’S been growing concern about the top-heavy nature of the U.S. market. Today, just 10 stocks account for 35% of the S&P 500’s total value. And while the largest technology stocks—dubbed the Magnificent Seven—have done exceedingly well in recent years, their extreme outperformance is making people nervous.
Observers are comparing today’s market to past periods when certain groups of stocks appeared similarly flawless. Consider the late 1990s, when companies such as General Electric dominated the market. GE was for a time the largest company in the S&P 500 until it essentially disintegrated. Going back further, in the 1970s, there was the Nifty 50, which included once-admired companies like Xerox, Polaroid and Kodak. For all these reasons, there’s been a growing unease about the state of today’s market.
A week ago, I discussed one possible solution: To offset the risk posed by a top-heavy market, investors could incorporate a value-oriented fund into their portfolio. Another approach would be to own a fund tracking an alternative to the S&P 500 known as the S&P 500 Equal Weight Index. As its name suggests, this version of the S&P 500 holds each of the 500 stocks in equal amounts—about 0.2% each. Result: The Magnificent Seven as a group would account for just a 1.4% weighting, far less than their 31% weight in the standard index. Should the performance of these stocks be less magnificent in the future, this would lessen the impact.
Equal weighting’s potential benefit is clear. If we look back to years when the market struggled, we can see how an equal-weight strategy would have helped. In 2022, when the S&P 500 dropped more than 18%, the equal-weight index lost less than 12%. And it wasn’t just that one year.
Over the past 20 years, the equal-weight index has outperformed the standard index in nearly half of annual periods, so equal weighting might seem attractive. But when it comes to investing, we’re stuck with the age-old conundrum: that all data are necessarily backward-looking, while all decisions are—by definition—forward-looking. In other words, there are no guarantees.
Owing to its structure, the equal-weight index has challenges of its own. For starters, there aren’t many options for investing in this index. Like any market where there isn’t a lot of competition, costs end up being higher. The most popular equal-weight ETF is an Invesco fund (symbol: RSP) with an expense ratio of 0.2%. By way of comparison, the Vanguard ETF that tracks the standard S&P 500 (VOO) charges just 0.03%.
Another point in favor of traditional market indexes: While it’s easy to fret about the ability of the Magnificent Seven to remain as exceptional as they’ve been, it’s important to give them their due. There’s a reason they’ve become so valuable. Look at them through virtually any lens—revenue growth, market share, profit margins—and you’ll see how different this handful of companies is from nearly all its peers.
And their scale is enormous. Netflix has 278 million subscribers. Amazon has 200 million Prime members. Each day, 3.3 billion people use Meta’s apps Facebook, Instagram and WhatsApp. Last year, Apple sold 234 million iPhones and brought in revenue of $383 billion. That’s more than the revenue of the smallest 107 companies in the S&P 500 combined.
There’s a more fundamental reason why you might not want to jump with both feet into an equal-weight index, and this is maybe more philosophical. Investment researcher Darius Foroux makes the following argument in favor of the traditional, market-cap weighted index. Referring to the Magnificent Seven, he writes, “They’re not just big. They’re the winners in our economy…. Each of those seven companies dominates their industry. When you opt for a market-cap-weighted index, you’re placing a bet on these winners. In finance, winners take most of the rewards. So that’s where you want to be.”
It’s an interesting argument, and it has a lot of validity. But this is where investors also need to keep their feet on the ground. Just because a company is a winner and has been growing quickly doesn’t guarantee future success. Indeed, many of today’s Magnificent Seven were once startups themselves and supplanted competitors that, at the time, looked dominant. Netflix unseated Blockbuster. Facebook overtook MySpace. The iPhone drove BlackBerry into obscurity. And Microsoft, led by a 20-year-old Bill Gates, displaced IBM from its position atop the computer industry.
The valuations of these companies present risk because they assume continued success. Consider Amazon's price-to-earnings (P/E) ratio of 32 based on next year’s projected earnings of $5.80 per share. If earnings continue to grow at a pace similar to what we’ve seen in recent years—between 20% and 30% per year—that valuation multiple doesn’t look too unreasonable. If Amazon earns $7.30 a share in 2026, as Wall Street expects, then its P/E multiple based on 2026 earnings would be closer to 26—still high, but much more reasonable than the current 32.
But if earnings fall short of expectations, the stock could suffer what’s known as a “re-rating.” That occurs when investors decide that a company’s growth prospects are less certain and, as a result, assign its stock a lower multiple. That’s a dreaded scenario for a stock: A lower earnings number multiplied by a lower P/E ratio could translate to a far lower share price. Worse still, re-ratings tend to occur quickly and without warning.
We saw this sort of thing just recently. Tesla held an event to show off a set of new products, but investors were distinctly unimpressed, causing the stock to fall 9% in a day when Wall Street analysts cut their earnings estimates for the coming years.
Where does this leave us? If the traditional market index is top-heavy, but the equal-weight alternative has drawbacks of its own, how should investors thread the needle on this question? The first step I recommend is to conduct a risk assessment. If the concern is about the concentration in the S&P 500, start by giving your portfolio an X-Ray. See how much you have riding on the S&P. If you have a balanced portfolio of stocks and bonds, and if the stock side of your portfolio is diversified, the overall concentration risk may be modest.
On the other hand, if you find that your portfolio is very heavily weighted toward the most expensive stocks, you might consider a small position in an equal-weight fund.
Choosing to diversify means there will, by definition, always be something that’s underperforming in your portfolio. That can be frustrating, especially when it seems so easy to make money by betting only on what’s worked in recent years. But that, as we know, is what psychologists call recency bias. And that’s why, as always, I recommend a balanced approach, one which allows investors to sleep at night no matter which way the market goes.
Adam M. Grossman is the founder of Mayport, a fixed-fee wealth management firm. Sign up for Adam's Daily Ideas email, follow him on X @AdamMGrossman and check out his earlier articles.The post Equally Bad? appeared first on HumbleDollar.
