The major stock indexes appear virtually unstoppable.
But while the S&P 500 and Nasdaq 100 continue to hit new record highs, investors should start to be wary of the benchmark indexes because they are market-capitalization weighted, making them more susceptible to the whims of larger companies, says Nate Geraci, president of asset management firm ETF Store.
In other words, the historic bull market currently unfolding is being driven primarily by a handful of large-cap stocks like Nvidia, Microsoft and Google, which are accounting for the bulk of the performance of the S&P 500 and Nasdaq. At the moment, this reality is good for passive index investors, as many individual stocks are struggling.
However, it is entirely possible that things could turn around in the future.
“If, for example, Nvidia or Microsoft or Apple or the tech industry as a whole starts to experience negative sentiment or trading moves in the opposite direction, I think there’s an inherent risk there,” Djerassi told Business Insider in an interview on June 18. “The challenge is predicting the top.”
Many strategists, including Adam Turnquist of LPL Financial, are keeping a close eye on the market weakness. In a June 14 note, Turnquist noted that even though the S&P 500 hit an all-time high on June 11, only 34% of stocks closed above their 20-day moving average. That’s the lowest participation rate in a record high since data collection began in 1990, he said.
“The lack of breadth and momentum confirmation doesn’t mean the bull market is over, but it does suggest that stocks may be taking a pause or even turning lower unless the rally extends,” Turnquist said.
Three Alternatives to Market Cap Weighted Indexes
To combat the S&P 500’s growing concentration risk, Djerassi offered three alternative investment approaches to consider.
First, he Equal weight indexall members have the same influence. In a scenario where a stock like Nvidia falls, this could minimize the damage it does to the market-cap-weighted S&P 500. Of course, limited participation would also limit any further upside from a stock like Nvidia.
Examples of these equal-weighted indexes include the Invesco S&P 500 Equal Weight ETF (RSP) and the First Trust NASDAQ-100 Equal Weighted Index Fund (QQEW).
Secondly, Djerassi said he would consider investing. Small Capare trading at much cheaper valuations than larger caps. Moreover, the possibility of monetary policy easing soon could favor smaller companies that are more heavily leveraged and more vulnerable to interest rate fluctuations.
“In theory, small caps could respond well if the Fed cuts rates one or more times,” Geraci said.
Vanguard Small Cap ETF (VB) and Schwab US Small Cap ETF (SCHA) provide exposure to small-cap stocks.
And thirdly, International StocksGeraci said they are lagging far behind U.S. stocks.
“There was a significant drop in performance there, but it seems there was a real change in sentiment,” he said.
He said both developed and emerging markets outside the United States were attractive.
Vanguard FTSE All-World ex-US ETF (VEU), Dimensional World ex US Core Equity 2 ETF (DFAX), and iShares MSCI Emerging Markets ETF (EEM) provide exposure to international equities.
