# The Five Stocks Driving the Market in 2023

An episode of [Patrick Boyle On Finance](https://invisiblenetwork.ai/podcast/1547740313), 5 Aug 2023, 20 min.

Audio: https://anchor.fm/s/fc0914e0/podcast/play/92761820/https%3A%2F%2Fd3ctxlq1ktw2nl.cloudfront.net%2Fstaging%2F2024-9-8%2F387759578-44100-1-827b5dbe30103dd9.mp3

Send us a textThe performance of the US stock market is the most concentrated it has ever been. Seven of the biggest stocks — Apple, Microsoft, Google owner Alphabet, Amazon, Nvidia, Tesla and Meta — have rallied sharply this year gaining between 35 per cent and 210 per cent this year. The remaining 496 stocks have barely moved.Five big tech companies make up nearly a quarter of the S&P500. At $3.1trillion dollar market cap, Apple alone is worth more than the Russell 2000 index of compani...

## Transcript

[0:00] Hello and welcome you are listening to Patrick Boyle on
[0:03] Finance, a podcast exploring ideas from quantitative finance,
[0:08] examining events occurring in markets right now and financial
[0:11] history to see what lessons can be taken away, including
[0:15] interviews with some of the most interesting people in the world
[0:18] of finance. To learn more about the podcast,
[0:20] visit on finance.org. Investing in an index fund is
[0:29] one of the best investment moves you can make.
[0:32] Index funds have low fees, they're tax efficient, they tend
[0:36] to generate good returns over time, and most importantly, they
[0:40] provide diversification. Or at least they're supposed to.
[0:44] Historically, index funds have outperformed actively managed
[0:48] funds and this is mostly due to their lower fees.
[0:52] Many of the big stock indices like the S&P 500 and the NASDAQ
[0:56] are not nearly as diversified as they used to be, and this is a
[1:01] growing problem. There are two main uses for a
[1:04] stock market index benchmarking and investment.
[1:08] Initially, stock market indices existed to inform investors of
[1:13] how well the overall stock market was doing, and this was
[1:17] their main purpose for a very long time.
[1:20] Stock market indices were already 87 years old in 1971
[1:26] when BGI launched the first index fund, followed by Vanguard
[1:31] a few years later in 1975. Index funds, which were at first
[1:36] ridiculed and called on American for setting mediocrity as a
[1:40] goal, now control 20 to 30% of the American equities market, if
[1:46] not more. The function of a stock index
[1:49] today is more to provide a list of stocks for index funds to
[1:53] invest in than to inform investors of how the overall
[1:57] market is doing. The S&P 500, the index that most
[2:02] investors pay attention to, is off to a great start this year.
[2:07] It's up around 19% year to date. And while that's great.
[2:11] The returns of the index have mostly been driven by seven of
[2:15] the largest US tech companies Apple, Microsoft, Alphabet,
[2:20] Amazon, NVIDIA, Tesla and MEDA. You know, Facebook.
[2:26] These stocks are up between 35% and 210% year to date.
[2:32] The remaining 496 companies are, in aggregate, about flat.
[2:38] Technology companies make up 28.1% of the S&P 500.
[2:44] And for those who consider Tesla a technology company rather than
[2:48] an automaker, as S&P classified technology is then 29.9% of the
[2:55] overall index by weight. The top five stocks in the S&P
[3:00] 500 Apple, Microsoft, Amazon, NVIDIA and Alphabet.
[3:06] Or Google represent nearly 1/4 of the market cap of the entire
[3:11] index. The top five stocks in the S&P
[3:14] at the peakofthe.com Mania in 1999 only made-up 16% of the
[3:21] index back then, which was not much higher than the historical
[3:25] average. The frothiest stocks at the time
[3:28] were not actually S&P constituents.
[3:32] Apple, with its $3 trillion market cap, is a loan worth more
[3:37] than the entire Russell 2000 index of smaller American
[3:41] companies combined, or more than the UK's top 100 listed
[3:46] companies combined. It has a weighting of 7.6% in
[3:50] the S&P 500. The tech sector has been heavily
[3:54] weighted in the S&P for some time now.
[3:58] It first hit 25% of the index back in February 2018 and has
[4:03] continued upward since then. That breakthrough in 2018 was
[4:08] the first time the sector made-up at least 1/4 of the S&P
[4:12] sincethe.com bubble. In 1999, the tech weighting of
[4:17] the S&P only got above 25% for the final four months of the.com
[4:23] bubble when share prices, particularly in the tech sector,
[4:27] were going nuts. To be clear, the problem with
[4:31] the.com era was that stock valuations had exploded beyond
[4:36] reason. Not that the market was too
[4:38] concentrated. Concentration was not the issue.
[4:42] Valuation was. So is valuation a problem today?
[4:47] Well, the forward P/E ratio for the technology sector stands at
[4:51] a little over 27 right now, compared with a peak of 60 in
[4:56] March 2000. This implies that valuations in
[5:00] the tech sector, while quite high, are considerably less
[5:04] stretched than duringthe.com bubble.
[5:07] And that the sector's heavy index weighting is more
[5:10] justified by fundamentals today than it was back then.
[5:15] There is growth in this sector, too.
[5:17] Half of the expected S&P 500 earnings growth in the fourth
[5:21] quarter of 2023 is expected to come from just four companies,
[5:27] according to FactSet. In its recent earnings Inside
[5:30] report, FactSet found that four percentage points of the 8.2%
[5:35] expected fourth quarter index earnings growth comes from Meda,
[5:40] NVIDIA, Alphabet and Amazon. Without these stocks, S&P
[5:45] earnings growth in the final quarter of the year is estimated
[5:49] to be 4.2%. So if the S&P is concentrated,
[5:54] what about the NASDAQ? The NASDAQ 100 wasn't
[5:58] specifically set up to be a tech index.
[6:00] It's just an index made-up of 101 equity securities issued by
[6:06] 100 of the largest nonfinancial companies listed on the NASDAQ
[6:10] Stock Exchange. And while people think of it as
[6:13] a tech index, it's actually just 57% tech stocks, or just over
[6:19] 60% if you count Tesla as a tech company.
[6:22] Individual company weightings are even more concentrated on
[6:26] the NASDAQ. As of yesterday, Apple made-up
[6:30] 11.7% of the index, Microsoft was 9.4%, Amazon 5% and so on.
[6:39] The way most indices like the S&P 500 and the NASDAQ 100 are
[6:43] constructed is that each company is weighted based on its market
[6:48] value. So bigger companies matter more
[6:50] than the smaller, less valuable companies do.
[6:54] As companies market values change over time, they're
[6:57] weighting in the index goes up or down.
[7:01] This means that the index is always representative of the
[7:04] overall growth of the companies that meet the index inclusion
[7:08] criteria. In 1990, IBM was the leading
[7:12] global company and Apple was a tiny upstart.
[7:16] So IBM was the heaviest weighted stock in the S&P 500, and Apple
[7:21] ranked 107th on the list. Now that Apple is more
[7:26] economically relevant than IBM, the two companies index ranks
[7:30] have changed. Apple is now #1 and IBM is
[7:34] around 60. Index investors didn't have to
[7:37] buy or sell any shares to adjust for this change, and they didn't
[7:41] get hit by any capital gains taxes either.
[7:45] The weightings adjusted as one company that they owned
[7:48] outperformed another company that they also owned.
[7:52] The investors at any point in time between those two dates,
[7:56] owned a basket of stocks that was representative of big
[8:00] business in the United States at that point in time.
[8:04] These indices work just fine as a measure of how American
[8:08] companies are doing overall, but with Apple being weighted at
[8:12] almost 12% in the NASDAQ and over 7 1/2% in the S&P, they're
[8:18] not looking like great diversifiers.
[8:21] You might think that it doesn't matter, but index funds are
[8:25] mutual funds, and there are SEC and I Rs rules that encourage
[8:29] mutual funds to diversify their holdings if they want to be
[8:33] classified as a diversified fund.
[8:36] Under those rules, diversification roughly means
[8:39] having at least half of a fund's assets in companies that each
[8:44] make up less than 5% of its portfolio.
[8:47] Early last month six companies Microsoft, Apple, Alphabet,
[8:52] NVIDIA, Amazon and Tesla. So their combined way to reach
[8:56] 50.9% of the index. This meant that something had to
[9:01] be done. NASDAQ needed to change the way
[9:04] the index was calculated because its customers have regulatory
[9:09] diversification requirements and the main business of an index
[9:12] provider is not to provide interesting information to news
[9:16] organizations. It's to come up with an
[9:19] investable portfolio so that it can charge a fee to asset
[9:23] management firms who track the index as a result of the growing
[9:28] concentration in the NASDAQ 100. NASDAQ announced a special
[9:33] rebalance, the 1st that they've ever done, which took place on
[9:37] July 24th to redistribute the weight of the index as members.
[9:43] This could happen again if the biggest stocks continue to
[9:46] outperform their smaller peers. The fact that a few companies
[9:50] are driving most of the returns of US indices is not really
[9:54] anything new. There are always hot stocks that
[9:58] pull away from the pack. In the 1960s it was the nifty 50
[10:02] with stocks like I, BM, Kodak and Xerox.
[10:05] We saw a similar situation with the oil companies in the past
[10:09] and today the mega cap tech stocks are enjoying their time
[10:13] in the spotlight. This year, Generative A I has
[10:17] fueled a powerful stock market rally, helping to pull the
[10:20] entire U.S. stock market higher. And the simple explanation for
[10:25] some of the extreme concentration that we're seeing
[10:28] is that a small number of companies are making a lot more
[10:31] money than most of the others are.
[10:34] These companies also happen to be at the forefront of
[10:37] technologies like a I. Now this doesn't explain
[10:41] everything. There is plenty of hype in there
[10:44] too. But this is not the same as
[10:46] the.com bubble, where unprofitable companies became
[10:50] extremely valuable for a short period of time.
[10:53] There's a very high correlation around .8 between the earnings
[10:58] being generated by companies and their weights in the index.
[11:03] Kathy Woods Arc Innovation Fund, which mostly invests in
[11:07] unprofitable companies, is not rising in line with the NASDAQ.
[11:12] Christopher Bloomstrand on eggs.com or Twitter points out
[11:17] that the NASDAQ 100 is back to being only 5% below its all time
[11:22] high, while the ARC Innovation Fund remains 68% below its 2021
[11:29] top because profits and price do seem to matter. 82% of Arc's
[11:35] capital is in profitless enterprises while 99, 1/2% of
[11:40] the NASDAQ 100 weight is in profit generating companies.
[11:46] If you were to weight the S&P 500 by net income rather than by
[11:50] market cap, you would find similar overall weightings to
[11:54] what we're seeing today. A few of the names would
[11:57] exchange places and there would be less concentration in the top
[12:02] holdings, but nothing too dramatic.
[12:05] There is fraud, but it's maybe less extreme than you might
[12:08] imagine. The excitement around Generative
[12:12] A I has obviously been the big tech story of 2023 so far, and
[12:17] this has been a big driver of a lot of the performance that
[12:21] we've seen in tech stocks this year.
[12:24] Growing interest in ESG investing has also driven
[12:27] investment into the tech sector at the expense of out of favor
[12:32] sectors like oil and gas. If you're going to rank
[12:35] companies by how much CO2 they produce, advertising and
[12:39] software companies are going to do well in such a ranking.
[12:43] The growth of the US tech sector is not just ESG and a I hype.
[12:49] A big part of the growth is driven by EU S's global
[12:53] leadership in consumer facing technology, which has brought
[12:58] about this cluster of highly profitable and durable
[13:01] companies. Second quarter earnings from
[13:04] these companies have been beating expectations so far.
[13:09] But in their earnings calls, they have not been prepared to
[13:12] predict when new A I features will show up in their products
[13:16] and services or what they hope to eventually charge for the
[13:20] technology. Amy Hood, Microsoft CFO, told
[13:25] investors on an earnings call last week that the revenue
[13:29] impact would be gradual as the features are launched and start
[13:33] to catch on with customers. Somewhat surprisingly for a
[13:37] group of companies that are heavily growth focused, cost
[13:41] discipline has contributed to the earnings outperformance this
[13:45] year. Many of these firms have cut
[13:48] headcount, some quite dramatically, in the last 12
[13:51] months while continuing to grow. There might still be some signs
[13:56] of overvaluation, though. Scott Mcneely was the CEO of Sun
[14:01] Microsystems, one of the hottest tech stocks of the late 1990s.
[14:06] At its peak, the stock was trading at 10 times revenues.
[14:10] A few years after the bubble at burst, he had this to say about
[14:14] the stock's valuation a 10 times revenues.
[14:19] To give you a 10 year payback, I have to pay you 100% of revenues
[14:24] for 10 straight years in dividends.
[14:27] That assumes I have 0 cost of goods sold, which is very hard
[14:31] for a computer company. That assumes 0 expenses, which
[14:36] is really hard with 39,000 employees.
[14:39] That assumes I pay no taxes, which is very hard.
[14:43] And that assumes that you pay no taxes on your dividends, which
[14:47] is kind of illegal. And that assumes that with zero
[14:51] R&D for the next 10 years, I can maintain the current revenue run
[14:55] rate. Now, thinking through that,
[14:58] would any of you like to buy my stock at $64 per share?
[15:02] Do you realize how ridiculous those basic assumptions are?
[15:06] You don't need any transparency. You don't need any footnotes.
[15:10] What were you thinking? It's hard to disagree with the
[15:13] point he makes on excessive investor optimism, But right now
[15:18] Tesla, a manufacturing company, is trading at around 10 times
[15:23] revenues, just like Sun Microsystems was, and NVIDIA is
[15:27] trading at around 44 times revenues, a lot more.
[15:32] NVIDIA, riding the wave of a I investor enthusiasm and
[15:36] scrapping its original revenue guidance for the coming quarters
[15:40] in favor of more bullish predictions, has gained $640
[15:44] billion in market cap just this year alone.
[15:48] That's more than the entire value of Visa, but less than the
[15:52] value of Berkshire Hathaway. All of that value has been
[15:56] gained in seven months. By any measure, the
[16:00] concentration that we're seeing in stock indexes driven by stock
[16:05] performance has reached an extreme.
[16:08] The run up of a handful of stocks is masking a lack of
[16:12] performance from the vast majority of both US and global
[16:16] stocks, and is complicating investment decisions both for
[16:20] stock pickers and index investors.
[16:23] Stock pickers who've attempted to stay diversified will have
[16:27] underperformed the index as they won't have owned enough of the
[16:30] top performers. And as we've seen with the
[16:33] NASDAQ example, index providers have been struggling to keep
[16:37] their indices investable. This has led many market
[16:41] commentators to warn that we're in a bubble and that difficult
[16:45] times lie ahead. This year, MSC I's index of
[16:49] global value stocks has fallen about 12% and the FT is
[16:54] reporting that value investing, the strategy of buying cheap
[16:58] stocks in often unfashionable industries, is suffering its
[17:02] worst run in 200 years. This extreme level of stock
[17:07] performance concentration can resolve itself in one of three
[17:11] ways. Things can continue on getting
[17:14] more and more concentrated. The rest of the market can catch
[17:18] up with the leaders, or today's hot stocks can fall back by
[17:22] underperforming in the future. Is there a market signal in the
[17:26] data, you might ask? Well, Max Kettner at HSBC wrote
[17:31] in a note to clients that increased performance
[17:34] concentration in itself does not throw off a strong, reliable
[17:38] trading signal. If anything, at the margins,
[17:42] concentrated performance may even be positive.
[17:45] He says that the immediate market performance following
[17:48] weak market breadth is better compared to when equity market
[17:52] breadth is strong. Vic Niederhoffer, in his book
[17:56] Practical Speculation, found that the relative rankings of
[18:00] index sectors show negative correlation between years,
[18:05] meaning that the best performing sectors of one year are often
[18:08] the worst performing sectors of the next year and vice versa.
[18:13] The take away is possibly that investors should plot a steady
[18:18] course and avoid chasing market trends or getting too carried
[18:22] away with the hype stocks of any given moment.
[18:25] The S&P 500 equal weight index weighs S&P 500 companies equally
[18:32] rather than by market value, and investors who are concerned
[18:36] about the lack of diversification in a market cap
[18:39] weighted index might consider investing in it.
[18:43] When you look at the long term returns of this index, it has
[18:46] outperformed the market cap weighted S&P slightly, but with
[18:51] greater volatility. The equal weighted index has
[18:54] been 10% more volatile than the regular S&P 500 since 1990.
[19:00] Most of its long run outperformance occurred during
[19:04] the bursting ofthe.com bubble in 2000 and again in 2009 in the
[19:10] wake of the credit crunch. It's worth noting that an
[19:13] investor in an equal weighted index like this will be paying
[19:17] more in taxes as the index is constantly selling stocks as
[19:21] they rise and buying other stocks as they fall, so it's
[19:25] less tax efficient than the market cap weighted index.
[19:29] Depending on your tax rate, any outperformance may be entirely
[19:33] wiped out by the taxes you have to pay each year.
[19:37] Thanks for tuning into today's podcast.
[19:40] If you're not already aware, all of these podcasts are available
[19:43] in video format on YouTube too. A special thanks to my Patreon
[19:48] subscribers who support makes this podcast work.
[19:52] Have a great week and I'll talk to you again soon.
[19:54] Bye. If you enjoyed this episode, be
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[20:05] If you enjoyed this content, you can find more like it on
[20:08] YouTube, on the Patrick Boyle on Finance channel or follow us on
[20:12] Twitter. Patrick eboyle, thanks for
[20:15] listening. Bye.

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