Source: JPM Chase
“Stop trying to put 10 pounds of shit in a 5 pound bag.”
I had an editor who was very fond of telling me that. It was his way of suggesting I keep my columns short and tightly focused on one big issue.
Unlike blogging, where digressions can turn into tangents and then become diversions (and no one cares), professional publications (Bloomberg, Washington Post) requires the writing ne structured and focused. The trade-off is that related topic issues can get short shrift in a 750-word column.
This week’s column on Index Concentration is a good example. The key was the top 10 stocks in the S&P500 at a 27% weighting does not represent a specific threat, as it was only a little above its 40-year range of 17.5% to 27.5%. There was a lot of related tangents I did not get to delve into.
Below are some ideas which I might have also liked to develop:
• Denominator Blindness: I have seen a dozen commentaries, columns and analyses, all of which decried the 27% for the top 10 (or 22% for the top 5) concentrations of stocks in the index as risky, excessive, or dangerous. Not one explained what the historical levels were, how the current situation developed, and why this present concentration was risky. One single number out of any context is classic denominator blindness.
• Absolute/Relative Performance: Why do we have a concentration of stocks in the top 5 or 10 holdings in the index?
Sometimes, all stocks are doing well, and it is merely the nature of a market cap weighted beast: Over time, capital flows will benefit the biggest stocks the most and we those holdings become larger as a percentage of the index. Other times, those stocks do incredibly well on their own, and because of that become bigger. Their success attracts capital, they become larger, and then each quarterly rebalance works to their advantage.
• Relative AND Absolute Performance: Then there has been 2020: Not only have the top 10 stocks done very well, most of the next 490 have done exceedingly poorly. This turns out to be a rather unusual situation. Most of time, the economy eventually works its way through all of the various market cap groupings. But the uniqueness of the pandemic and lock down has created a very unusual situation.
Once the lockdown ends, some mean reversion occur, as the prior economic structures reassert themselves. If there is at least some historical relationships are restored, might the advantages of the top 10 moderate?
• Externality: Finally, might we have seen a permanent change in the indices? Has the migration to a more technologically advanced future been accelerated? What if the lockdown accelerated technological adoption forward by 2 years? Not a temporary Y2K spending bump, but a leap forward by 8 Qs of spending, permanently shifting the balance forward?
That suggests that when all this is over, perhaps some of the FAANMG advantages will stick.
Perhaps the economic dinosaurs may soon find themselves replaced by smarter, more adaptable mammals…
Top-Heavy Stock Indexes Are Nothing to Fear (August 18, 2020)
Criticism of Concentrated Index Risk Are Off Base (August 21, 2020)
Don’t Suffer From Denominator Blindness (October 14, 2015)
FAANMG Stock Prices Reflect Global, Not US Recovery (July 17, 2020)
Maybe Mr. Market Is Rational After All… (August 7, 2020)
How Externalities Affect Systems (August 14, 2020)