When you think of the “market index,” typically the S&P 500, there is usually an assumption of diversification. After all, the S&P 500 is composed of 500 of the largest company stocks in the United States. However, indexes themselves were not developed to be diversified in a way to reduce risk nor were they meant to be used as efficient portfolios. Most indexes, like the S&P 500, were created to measure market capitalization. Sometimes, the stocks within the S&P 500 are fairly balanced, and other times, not so much. Right now, the market is very distorted towards just a few very large names.
The S&P 500 may be composed of a little more than 500 individual securities, but the index itself will move in the same direction as just a few very large stocks. Look at the chart below, which shows how many of the S&P 500’s components it would take to account for X% of the index’s market cap. Bottom line, it only takes 39 of the 500 stocks to get to 50% of the S&P 500’s market capitalization, and only 127 stocks to get to 75%.
As a matter of fact, Apple (the largest S&P 500 stock), is larger than the smallest 200 S&P 500 stocks combined!
Where does the market’s skewedness cause issues? Obviously, it causes an issue when technology stocks experience bear markets, like the one seen in 2022. In general, technology stocks dragged the market down with it, while some more value-oriented sectors outperformed. On the other hand, the market’s heavy tilt towards technology stocks causes an issue when looking at the overall health of the market.
Right now, there are only two S&P sectors that have positive relative strength to the market index. Those two sectors are Information Technology and Communications, which combine for 36% of the S&P 500 capitalization. The other nine S&P 500 sectors are displaying falling relative strength, meaning they are underperforming the market on a relative basis.
When we take a look at the individual S&P 500 stocks, only a few are showing positive characteristics. For example, take just the largest 150 US securities, which account for 78% of the S&P 500’s capitalization. Using Canterbury’s Market State Indicators (which measure a security’s risk level) as well as relative strength indicators, we composed a list of “buys,” “holds,” and “sells.” Out of the largest 150 S&P 500 securities, only 42 of them showed “buy” characteristics, while 81 were listed as “sells.” In other words, there is a small percentage of stocks, mostly technology-based, that are showing positive momentum, while several stocks are falling off.
The more you look at this market, the more vulnerable it appears.
Market strength is being carried by its largest technology-related securities, many of which have experienced sharp, parabolic advances in a matter of just a few weeks. A growing number of market constituents are exhibiting negative characteristics. The generals are out leading the battle, while the troops retreat. That does not point to a healthy market.
The current state of bonds is also concerning. In general, bonds have been falling off over the last few weeks. While the volatility of bonds has also declined, they have yet to show any signs of positive momentum.
To deal with a vulnerable market, the Portfolio Thermostat remains well diversified. It has exposure to Information Technology as well as Communications, but it will not have nearly 40% in those sectors. While many other sectors are falling off, the Portfolio Thermostat has inverse exposure to them. Inverse securities move in the opposite direction of their underlying index. This creates a more stable fluctuating portfolio regardless of if volatility rears its ugly head.
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