19 June 2023

Almost no day passes without an article in the media that emphasizes the huge current weight of mega-cap tech stocks in the S&P 500 Index.

Seven mega-cap tech stocks currently have a combined market capitalization of approximately $10.6 trillion (June 16th, 2023). The whole combined market capitalization of the S&P 500 Index companies is approximately $36.8 trillion (May 31s, 2023).

Not only the total weight of these stocks is disproportionately large, but it also enacts a powerful influence on index performance. According to S&P Global, without these 7 stocks, the S&P 500 would be down 0.8% on the year, through May 16th, 2023.

According to explanation provided on S&P Global website (quote):

“These seven mega-cap stocks have all significantly outperformed the rest of the index as investors have moved to the relative safety of Big Tech amid ongoing interest rate hikes, stubbornly high inflation, the persistent threat of a recession, and the debt ceiling drama in the US”

A reasonable explanation. But this narrative reminds immediately of panicking, or otherwise very emotional, crowds. And crowds, as we recently witnessed can create for example … right: GameStop. You can read SEC (Securities and Exchange Commission) report on GameStop here.

And the same crowds also made hedge funds and institutional investors, among them Melvin Capital and Citron Melvin Capital to lose $19 bil in January 2021. Melvin Capital lost $6.8 bil in a month.

There were calls to involve SEC, enact new regulations, but regulators and lawmakers reacted passively to all of this (more or less), and let it happen.

There were The House Committee on Financial Services investigation and hearings.

SEC investigated the frenzied trading in shares of GameStop and other meme stocks, but in the end, it did not recommend any specific changes or regulations.

I believe the reason for this is that the case of GameStop did not pose a systemic risk to the system. Plus from a PR perspective, the losers were sophisticated hedge funds, so who cares about them.

However, one cannot say the same of the S&P 500 Index.

Speaking of Black Swans, they might be black, but the point is not if they are black or white. The point is that they do exist.

And they certainly can happen with current structure of the S&P 500 Index.

According to S&P Global, an estimated $15.6 trillion is indexed or benchmarked to the index, with indexed assets comprising approximately $7.1 trillion.

In a recent publication, Morgan Stanley Wealth Management Chief Investment Officer, Lisa Shalett, emphasized that investing in S&P 500 in its current format no longer provides investors with true diversification.

One might argue, and it is true, that the responsibility here falls on investment advisors, investment managers, and investors themselves.

But if you remember subprime, responsibility fell on many parties shoulders in that case as well. But it not only did not solve the problem but even exaggerated it.

So in case of S&P 500 current situation, at least partial responsibility falls on shoulders of the company developing the index, S&P Global itself.

I think it might be a good idea for S&P Global to react proactively to current market reality instead of waiting for Black Swans and change the index.

One option is to remove these seven mega-cap tech stocks completely from the index and create a separate index for them.

The other option is to change the weightings policy of the index and move it closer to an equal-weighted index, so to speak.

The third option is to cap the weight of these mega-cap tech stocks to a certain limit, say 15% percent, as a group, and equal-weight these stocks inside this allocation.

If everybody will just pretend that everything is fine, at some point in time the SEC investigations and The House Committee on Financial Services hearings will follow through, and it is always a pleasure to read their reports with a glass of good wine in hand.