An interesting thing about index funds, which hardly anybody ever talks about, is that when a stock or a sector posts dramatic gains, it can become an outsized part of the total index. Investors who buy the index are buying that stock or sector at very high valuations—which may nor may not end well.
The chart here shows the percentage of the S&P 500 that is made up of its five largest stocks, dating back to the early 1960s. Back then, the “nifty fifty” stocks enjoyed very high stock prices, which ultimately didn’t end well. Then, if you look at 1999 and 2000, you see how a small number of tech stocks dominated the index, which ultimately led to the so-called “tech wreck” market decline.
Look at the right side of the graph, and you see that five tech stocks—Microsoft, Amazon, Apple, Google and Facebook—today represent more than a fifth of the total value of the 500 stocks in the S&P index. Microsoft alone now represents about 5.5% of the index, which happens to be higher than its peak weighting during the dotcom bubble.
Moreover, a blog post entitled The Irrelevant Investor, by Michael Batnick of Ritholtz Wealth Management, notes that other tech firms are also doing pretty well these days. The 100 mostly-tech stocks on the Nasdaq index are now worth as much as the MSCI World ex-USA Index, which includes more than a thousand large and mid cap stocks from developed markets outside the United States.
How will this end? Who knows? But if history is any indicator, sooner or later stocks that balloon in value will come back to earth, and the broad index will become more balanced. As always, the timing is uncertain.
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