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Joseph Calhoun
Summary
- All markets – stocks, bonds, currencies, commodities – provide us with valuable information about the economy.
- The broader the index, the more representative it is of the economy as a whole.
- The way indexes are constructed makes a big difference in the information you can extract about the economy.
When people talk about “the market” they are usually referring the big indexes – the S&P 500 (SPX) or the Nasdaq. For those who aren’t really watching, “the market” is the Dow, which is a lousy index for a lot of reasons but has the advantage of history. But are those really representative of how “the market” is doing?
All markets – stocks, bonds, currencies, commodities – provide us with valuable information about the economy. The stock market generally reflects corporate profit growth and interest rates, which provides us with important feedback about the general economy. The broader the index, the more representative it is of the economy as a whole.
The way indexes are constructed makes a big difference in the information you can extract about the economy. The S&P 500 and the Nasdaq are capitalization-weighted, meaning the companies with the highest market value get a bigger weighting. As a company’s stock rises in value, the index is forced to buy more to keep the index properly ordered. In short, cap-weighed indexes are momentum indexes, with the index continually adding to the stocks that perform the best. That means the index’s performance is more a reflection of the largest and best performing stocks in the index. Everyone by now has heard about the Magnificent 7, so I won’t rehash all that, but the fact is that the performance of these two indexes is distorted because we have a small group of very successful companies.
The Dow is price-weighted, which means that the stocks with highest per-share price get the highest weights. That means that United Health Group has the largest weighting in the Dow, but 14th in the S&P 500. In the case of the Dow, companies are rewarded for not splitting their stock, and it also means that some great companies get excluded because they would make up too large a part of the index. It also means that companies that the index has to sell stocks that split their stock. In some ways, the index does act like the S&P in that the best performing stocks make up every larger parts of the index – as long as they don’t split their stock.
Most of the indexes in the world are capitalization-weighted weighted, but there are now a lot of indexes that are weighted based on a factor, like quality, or value, or growth. You can invest in just about any way you want by purchasing the proper index, but I think that, in some ways, distorts the purpose of index or passive investing. In its simplest form – and simple is almost always better – indexing should give you exposure to the broad market. You don’t get that with capitalization-weighted indexes, and you don’t get it with factor indexes. But cap weighted is the standard, so it’s what most people use.
If what you want is information about the economy though, I think it makes sense to look at a variety of indexes and when you do that for the YTD, you get an interesting result. The S&P 500 and the NASDAQ 100 have produced the best result by far, which isn’t surprising when you see their top 10 holdings:
Nasdaq 100 (QQQ): Microsoft (MSFT, MSFT:CA), Nvidia (NVDA, NVDA:CA), Apple (AAPL, AAPL:CA), Amazon (AMZN, AMZN:CA), Meta (META, META:CA), Broadcom (AVGO, AVGO:CA), Alphabet (Google) class A (GOOGL) and B (GOOG), Costco (COST, COST:CA) and Tesla (TSLA, TSLA:CA).
S&P 500: Microsoft, Nvidia, Apple, Amazon, Meta, Alphabet (Google) class A and B, Berkshire Hathaway (BRK.B), Eli Lilly (LLY, LLY:CA) and Broadcom.
8 of the top 10 holdings are the same, so the performance of the two is very similar. The top 10 make up 35% of the S&P 500 and 49% of the Nasdaq. If you want a better comparison, you can use the S&P 100, which is the top 100 of the S&P 500. The top 10 in that case makes up 50% of the index.
I don’t think one can make a good argument that these 12 companies represent the US or global economy. If we equal-weight the members of each index, we get a much different result. While the cap-weighted indexes are up in the mid-teens percent range, the equal-weight versions are up a lot less: S&P 500 equal weight +4.56% and Nasdaq 100 equal weight +4.3%. Outside the top 12, the rest of the market is not performing nearly as well. Although not really representative of the economy as a whole either – arguably I suppose – the Dow is also drastically underperforming the largest companies, +3.62%.
We get similar results if we look at mid and small-sized companies in the US and indexes outside the US: Midcap +5.41%, Small Cap -1.75%, Europe +7.22%, and International Developed markets (EAFE) +6.57%.
“The market” is still doing pretty good this year, with the exception of the smallest company stocks, but the largest companies are doing a lot better. And that in a microcosm represents the US economy, with a few companies doing really well and the rest of the economy doing a lot worse but still okay. Is that a problem? I think so, but that doesn’t mean I think we need a big push on antitrust to break up these big companies. I’m not generally in favor of government intervention because the market will take care of this eventually. There is considerable turnover in the top 10 holdings of the S&P and the Nasdaq, as successful companies with high margins see lots of competition.
But that is different than deciding whether you should invest in these indexes. There is plenty of evidence that the S&P 500 has been even more concentrated in the past than it is today. But people weren’t buying the SPDRs or the Qs in 1960. The warning sign for me in the S&P 500 is its similarity with the NASDAQ. If I wanted to invest in the biggest, riskiest – and arguably most innovative – companies in the US, I would buy the QQQ. Today, the S&P 500 and the Nasdaq are nearly indistinguishable.
The US and global economy is doing pretty well right now, with the US slowing some and the rest of the world, in general, getting a bit better. “The market” reflects that. The S&P 500 and the Nasdaq 100 reflect how the biggest companies in the world are doing. It was once said that what’s good for GM is good for America. I’m not sure you can say the same thing about Microsoft, Nvidia, Amazon, Google, and Meta.
Editor's Note: The summary bullets for this article were chosen by Seeking Alpha editors.
Joseph Calhoun
Joe has worked in the financial services industry since 1992 in various capacities, including Operations Manager, Compliance Manager, Registered Representative and Portfolio Manager. From 1997 to 2006, when he founded Alhambra Investment Management, Mr. Calhoun was a Director of Investments at Oppenheimer & Co. Mr. Calhoun holds the Series 63 (Uniform Securities Agent State Law) and 65 (Uniform Investment Advisor Law) securities licenses. He has previously taken and passed the Series 7 (General Securities Representative) and Series 9/10 (General Securities Sales Supervisor) securities exams.Joe proudly served in the U.S. Navy’s nuclear submarine service for 8 years (1983-1990) and was awarded several commendations including the Navy Achievement Medal in 1987. He studied engineering at the University of South Carolina and is a graduate of the U.S. Navy’s Nuclear Propulsion School. He founded Alhambra Investment Management as a registered investment advisory to address the needs of the individual investor. His market commentaries are widely read and published at various online outlets. He has appeared on Larry Kudlow’s program on CNBC and various radio programs. He is also an editor of the website RealClearMarkets.com.
