With the stock market flirting with record highs — and 30,000 in view for the Dow Jones Industrial Average — this is a good opportunity to check under the hood of your investment portfolio to see what you actually own.

If you have a 401(k) plan and haven’t evaluated it in a while, now’s the time to do that — because you might be less diversified than you think.

Many investors want broad diversification, as it helps to spread risk among hundreds if not thousands of stocks, bonds and other assets. Many have bought funds such as those pegged to the Standard & Poor’s 500 index that hold slices of 500 stocks. That’s normally good diversification, which helps to explain the popularity of S&P 500 index funds and their emergence in workplace 401(k)-type programs.

But there are times when diversification runs in reverse, especially as big, powerful stocks rise in value to take up bloated shares of these funds and drive an outsize amount of their investment performance. Such trends can be great while they last, but they invariably cool off.

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A possible danger with funds pegged to the S&P 500 and some other indexes is that the stocks they own aren’t equally weighted. Rather, they’re weighted by the stock-market value of each one. That means bigger, more valuable corporations exert more impact on overall investment performance. Right now, a handful of giants are tipping the scales.

The five biggest stocks weigh in at around 17% of the entire S&P 500, meaning the other 495 stocks account for the remaining 83%. Two giants in particular, Apple and Microsoft, combine for 9% of the total. All this is fine if the giants continue to surge. But if things reverse, they could drag down the funds dependent on them, taking down your portfolio with them.

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The current concentration of top-five stocks is the highest since before the dot-com bubble burst in 2000, wrote John Petrides, a portfolio manager at Tocqueville Asset Management, in a new report. Investors might remember that things didn’t work out so well back then for a lot of stocks — and the indexes and funds that held them.

Darlings of the S&P 500

Over the past three years, six companies in particular have driven the market higher, Petrides said in an interview. These are the FAANG stocks — Facebook, Amazon, Apple, Netflix and Google — along with Microsoft.

He said the two biggest holdings, Apple and Microsoft, are more valuable than four entire sectors or industry groups — energy companies, utilities, real estate stocks and those in basic materials such as metals, wood products and chemicals.

Indexes like the S&P 500 are passive, meaning there’s no portfolio manager pruning branches when certain stocks shoot up toward the sky.

This isn’t necessarily bad, as active fund managers who make bad judgment calls could wind up selling way too early. But it does create risks that many investors may not have considered, Petrides added.

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Industry concentration happening, too

Driven by these big stocks, a few industry groups or sectors are exerting outsize influence, too. Stocks in technology/communication services combine for about 34% of the entire S&P 500. If you include Amazon, which is categorized as a consumer stock, the concentration is closer to 36%, Petrides said.

A high concentration in certain industry groups isn’t uncommon, “but we have seen this story play out before,” Petrides wrote in his report.

In 1999, for example, technology and telecom stocks weighed in at nearly 40% of the S&P 500’s total value, but then came the dot-com bust. Financial stocks had a run later, reaching 22% in 2007, before the collapse of Bear Stearns and other sector weakness brought them down. Energy companies rose to 16% the next year, but the development of shale oil and other factors deflated their momentum.

Since the second quarter of 2012, the combined market values of the five biggest technology companies (excluding Netflix) have swelled by 374% to $5.5 trillion, reported Refinitiv, an information and technology company. So far in 2020 through Feb. 11, the big five were up 12% — a good annual gain in most years.

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Long-term trend

Petrides’ argument isn’t new. Other investment advisers have sounded the same alarm for months, yet giant stocks have continued to charge along. It thus can seem easy to dismiss the warnings, especially with a favorable economic backdrop helping to propel the market. But that doesn’t mean the warnings are wrong — possibly just premature.

The long upward ride of these giant stocks has boosted their valuations and that of many indexes, Petrides added. Stocks in the S&P 500 currently have an average price-earnings ratio around 18, meaning their shares are trading at 18 times what Wall Street analysts think the companies will earn, per share, over the next year or so. This compares to more normal valuations around 15 or 16, implying that the stocks and indexes are a bit pricey.

Much of that is justified, Petrides said, based on low interest rates, meager yields on bonds (a competitor to stocks), a healthy economy, rising dividend payouts and other factors. Still, there’s less room for error when stocks are pricey.

Switch to other investments?

So what to do? One possibility is to sell off some of your large-stock-dominated index funds. Selling isn’t easy to stomach when prices are on a roll or if selling would lock in taxable gains. But it’s something to consider.

Another option is to divert new investment dollars to other areas. One possibility, in Petrides’ view, are foreign stocks and markets, where valuations are more modest yet long-term growth prospects still reasonably bright. Though many stocks in the S&P 500 are multinational, these are still American companies.

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“The only international exposure an investor in the S&P 500 gets is through each individual company’s geographical diversification,” he wrote. Coca-Cola, for example, derives more than half of its revenue from foreign nations.

It’s easy to gain broad, instant exposure to actual foreign companies by investing in any of hundreds of international and global mutual funds and exchange-traded funds.

You also could invest in areas of the U.S. market that aren’t dominated by giant companies. Any of hundreds of small-company funds could do the job.

“We’re certainly not expecting (giant stocks) to collapse any time soon,” said Royce Investment Partners, a manager of small-stock funds, in a recent commentary. “But we do think a performance pause at their current high valuations could occur, allowing small- and micro-cap stocks to catch up.”

Focus on diversification

The key point is to remain broadly diversified and resist falling in love with today’s stock-market darlings and the funds that hold them. Petrides, an active stock manager who doesn’t follow a passive or indexing approach, believes now is a time to be cautious.

Many people have embraced index funds such as those holding the S&P 500 stocks, and for good reason. Over the long haul, this has been a highly successful strategy. But given elevated valuations, the lack of foreign stocks and unusually high concentrations in a handful of giant companies, now might be a time for prudence.

The odds are good that the current five or 10 top holdings in the S&P 500 won’t be the five or 10 biggest a decade from now. The S&P 500 index, currently, is not a “clear representation” of the overall stock market, Petrides said.

Reach Wiles at russ.wiles@arizonarepublic.com or 602-444-8616.



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