The Stock Market Is Too Narrowly Focused

The breadth of the stock market is a measure of its health, and the wider the better. So, a narrowing of its focus, as we’ve seen recently, is often a red flag, both for the overall market and the darlings of the moment.

The 10 largest stocks by market capitalization account for 30% of the S&P 500 Index’s total value, and five — Apple Inc., Microsoft Corp., Nvidia Corp., Alphabet Inc. and Tesla Inc. — accounted for about a third of the index’s 27% gain in 2021. In short, if anything goes wrong with that handful of equities, as well as mutual and exchange-traded funds based on the broad market, everyone might be in trouble.

As we all know, trees don’t grow to the sky. Investment firm Dimensional Fund Advisors examined the fate of a stock after it became one of the 10 biggest in the S&P 500. It found that in the decade before joining the club, a stock outperformed the broad market by 10% a year. Nevertheless, investor enthusiasm that pushed a stock into that elite category often pushed it too far, and it lagged behind the broader mark by 1.5% per year over the following decade.

If that’s not worrisome enough, the trailing price-to-earnings ratio of the S&P 500’s top tier in November was 68% higher than their average multiple over the past 25 years, according to JPMorgan Asset Management. And that quarter of a century included the tech-bubble years of the late 1990s.

In most periods of excessive speculation, the lesser lights are the first to fall before the woes spread to the leaders. In the tech arena, fitness equipment company Peloton Interactive Inc. plunged 76% in 2021, online resale platform Poshmark Inc. tumbled 81% and education tech company Chegg Inc. dropped 66%. These and other so-called stay-at-home companies aren’t necessarily headed for bankruptcy, but in 2020 their stock jumped much more than their sales and profits growth could justify.