Over the past two years, investors have been taken on quite the roller-coaster ride.
In 2021, the benchmark S&P 500 (^GSPC 1.02%) endured no worse than a 5% correction, while all major indexes -- the Dow Jones Industrial Average (^DJI 0.40%), S&P 500, Nasdaq Composite (^IXIC 2.02%), and Nasdaq 100 -- catapulted to record-closing highs. This was followed by a bear market in 2022, as well as a strong rebound for all four indexes over the past 10 months, which has been led by the Nasdaq 100 -- an index comprised of the 100 largest nonfinancial companies listed on the Nasdaq exchange.
The expectation from investors is that these indexes should act as an accurate barometer of stock market health. But this isn't always the case.
Image source: Getty Images.
The Nasdaq 100 was just rebalanced, but its "big" problem remains
A perfect example of a major stock market index failing to live up to the perception of diversification is the Nasdaq 100. Though it's an index with 101 components (one company has two classes of shares, thus 101 components and not 100), its weighting is highly concentrated in just a handful of megacap growth stocks.
Nearly three weeks ago, on July 6, eight components of the Nasdaq 100 accounted for more than 55% of the weighing of the index. In order, these eight components were:
- Microsoft: 13.023% weighting
- Apple: 12.505%
- Nvidia: 6.953%
- Amazon: 6.787%
- Tesla: 4.517%
- Meta Platforms: 4.319%
- Alphabet: Class A shares (GOOGL) 3.748%/Class C shares (GOOG) 3.661%
Recognizing that the year-to-date outperformance of these "magnificent seven" megacap companies had created this imbalance, Nasdaq announced plans to alter its weightings of the Nasdaq 100. That rebalancing took place on Monday, July 24.
The new weightings, following the rebalancing, are as follows:
- Apple: 11.616%
- Microsoft: 9.835%
- Amazon: 5.132%
- Nvidia: 4.211%
- Meta Platforms: 3.511%
- Tesla: 3.171%
- Broadcom: 3.085%
- Alphabet: Class A shares (GOOGL) 2.744%/Class C shares (GOOG) 2.719%
You'll note that the individual weighting for each of the magnificent seven has declined, and that wireless solutions company Broadcom has become an increasingly important component.
Nevertheless, the rebalancing of the Nasdaq 100 hasn't solved its "big" problem. While the magnificent seven no longer account for 55.51% of the index, their adjusted weighting still added up to 42.94%, prior to the opening bell on Monday, July 24. If Broadcom is added, we're talking about 46% of the Nasdaq 100's weighting coming from just eight megacap growth stocks (and nine components) with a strong leaning toward the tech sector.
In other words, the Nasdaq 100 is still just a concentrated megacap growth stock index. Nothing has meaningfully changed.
Image source: Getty Images.
The Nasdaq 100 isn't alone
To be fair, the Nasdaq 100 isn't the only major index that seemingly fails the diversification test. Movements in the iconic Dow Jones Industrial Average and broad-based S&P 500 have become increasingly reliant on a smaller number of stocks.
The Dow is an interesting case, because it's a price-weighted index. Whereas the S&P 500 and Nasdaq 100 take market cap into account, the Dow's value system is based entirely on share price. This means a company with a smaller market cap can have an outsized impact on the index if its share price is high.
As of July 21, five Dow components accounted for just a fraction shy of 34% of its weighting:
- UnitedHealth Group: 9.426832% weighting
- Goldman Sachs: 6.559373%
- Microsoft: 6.48478%
- Home Depot: 5.965429%
- McDonald's: 5.554884%
Goldman Sachs is currently the 26th largest Dow stock by market cap, yet it has nearly twice the influence of Apple, the largest publicly traded company, and more than double the influence of Johnson & Johnson, whose market cap is almost four times that of Goldman Sachs.
Outsized concentration is also prevalent in the market cap-weighted S&P 500. The magnificent seven comprise nearly 27.5% of the 503-component index, and surpass 29% with the addition of Berkshire Hathaway's Class B shares:
- Apple: 7.535378% weighting
- Microsoft: 6.806307%
- Amazon: 3.061441%
- Nvidia: 2.970876%
- Tesla: 1.86912%
- Alphabet Class A shares (GOOGL): 1.868831%
- Meta Platforms: 1.766046%
- Berkshire Hathaway Class B shares (BRK.B): 1.631178%
- Alphabet Class C shares (GOOG): 1.611999%
While bigger companies should have more influence within the major indexes, just eight companies, and nine total components out of 503, are responsible for 29.12% of the S&P 500's price movement. That's not diversified, and it's certainly not the best barometer of the health of the broader market.
This may be the best barometer of the stock market's health
With Wall Street's most prominent stock indexes reliant on a relatively small number of companies, investors are compelled to look elsewhere for a more accurate gauge of the stock market's health. The best solution to this "big" problem might be found in the exchange-traded fund (ETF) arena.
Investors wanting a realistic take on the health of the U.S. stock market would be wise to keep an eye on the Invesco S&P 500 Equal Weight ETF (RSP 0.05%). As its name implies, this is an index that holds all the components found in the S&P 500, but with a clear catch: equal weighting. Give or take a few basis points in each direction, every component in the Invesco S&P 500 Equal Weight ETF accounts for about 0.2% of its total weighting.
While it's true that megacap companies like Apple and Microsoft have a sizable impact on the U.S. economy and job market, an equal-weighted index provides a more comprehensive look at how large-cap and mid-cap companies are performing.
As you can see from the chart, the Invesco S&P 500 Equal Weight ETF was unchanged for the year until the early part of June. Since then, this equal-weight ETF has risen by roughly 9%. In other words, we've begun to see broader participation in this rally over the past two months.
However, don't mistake two months of a solid uptrend as Wall Street being perfectly healthy. Market participation has been predominantly skewed to the magnificent seven throughout 2023. Further, multiple indicators and metrics suggest economic weakness is likely for the U.S. economy in the months and quarters that lie ahead.
Though the long-term uptrend for the broader market remains decisively higher, the Invesco S&P 500 Equal Weight ETF still suggests a level of uncertainty and uneasiness persists among investors.
