In a Narrow Market, Amazon is Essentially Must-Own for Benchmark-Conscious Investors

Portfolio management is somewhat like gardening. Just as you need to prune your garden to keep if flourishing, so must you prune your portfolio. You need to pick through your holdings, isolate the underperformers and determine whether they are flowers to be nurtured or weeds to be removed.

In a narrow market, however, pruning a growth-oriented portfolio can be challenging given market leaders’ prominence in benchmark indexes. I believe that’s why we’re seeing unusual responses to earnings announcements in 2018. Normally, you’d expect strong earnings to lead to higher stock prices. But things are different when essentially everyone in the large-cap growth space owns—indeed, almost has to own—the market leaders. In this market, if you haven’t owned the handful of stocks that’s led, you’re lagging the benchmark and your peers. Period.

But with the FAANG stocks at all-time highs, it’s no wonder to us that growth managers appear to be ready to take any opportunity they can to trim their positions. Check the holdings of large growth funds, and you’ll often see 8% or more of a portfolio invested in one or more of the FAANG stocks. That can get uncomfortable for portfolio managers seeking to maintain diversification. So on any good news—the kind that nudges the stock price up further—holders of these stocks are trimming their portfolios. After all, many portfolio managers don’t want a single stock creeping into the 15% range—especially with valuations as extended as they are now based on historical standards.

The upshot is that strong earnings reports just aren’t translating into meaningful surges in stock prices, which further reinforces market narrowness—something already to be expected in a mid-cycle economic expansion. Narrowness makes it all the harder to find attractive opportunities apart from the well-known leaders.