Unbearable weight of heavyweights

Next week the U.S. Nasdaq stock exchange will adjust the weights of the Nasdaq 100 Index. Adjustment in this case means cutting the weight of the seven largest stocks so that they no longer account for a total of 56% of the index's market capitalization, but "only" 44%. In this way, the exchange wants to at least partially eliminate the imbalance from its index, caused by the price explosion in America's largest technology stocks. The index rose by a full 39% in the first half ^[1] of the year, making it the best half-year in its history. The Big 7 contributed over 30 percentage points of this 37% rise. For investors, this creates practical problems. Even those who buy the entire index find that more than half of their investment is concentrated in just seven stocks.

This phenomenon is even more annoying in the case of the S&P 500, which is much more broadly diversified than the Nasdaq 100. ^[2] Here, the Big 7 account for 30% of the index market cap and for almost all of this year’s gain. As an investor, you count on buying a reflection of the U.S. economy with the S&P 500 Index. But that’s not the case if the performance is largely dependent on less than a dozen stocks.

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Outperformance of the S&P 500 vs the equal weighted S&P 500

_{* Positive/negative values indicate outperformance/underperformance of S&P 500 (market cap weighted) over its equally weighted index}

_{Sources: Bloomberg Finance L.P., DWS Investment GmbH as of 7/19/23}

Our Chart of the Week illustrates this phenomenon by comparing the performance of the (market value-weighted) S&P 500 with that of the equal weighted S&P 500,^[3] in which each stock is given an equal weighting, regardless of its capitalization. Here you can see how stark the difference has been this year – as high as it last was in the late 1990s, the heyday of the dot-com bubble. If there are several of such years in a row (2017-2019) or if the difference is as marked as it has been so far this year, the heavyweights increasingly dominate the index. For those who have a problem with this and do not quite trust the flight to the top, consider the equal weighted S&P 500 as a benchmark, especially if the investor does not want to try to time the market but, rather, tends to buy and hold. With the equal weighted index, it would allow technology stock in a portfolio – which, we believe, is essential in the long run, as the tech sector has the potential to remain a growth engine, not least because of the artificial intelligence wave. But in the short term we are skeptical about these stocks as we believe their share price performance has run ahead of their earnings and of our earnings expectations for the sector.

From our perspective, this year's rally appears to be based solely on expansion of the sector's price-earnings multiples, not on any increase in profits. And there will likely be little increase in profits this year. We doubt whether the current record valuations (for example, for growth stocks against blue chips) will survive the coming months unscathed if the U.S. slides into a recession or interest rates stay higher for longer than expected. We also do not see it as a good sign when stock market investors are correcting the overweighting of a handful of companies in an index by themselves, by switching to equal weighted alternatives. We believe it is the antitrust authorities who ought to be intervening to correct the index’s weighting.