Top Heavy

Despite a strong year for the overall stock market, under the hood, things are a lot less shiny. Through November, the S&P 500 is up 18%. This index is market-cap weighted, meaning the bigger the company the bigger its representation. The same 500 companies, if equally weighed, are only up 3%. Small and mid-sized companies are barely in the green, but the “Magnificent Seven” of Apple, Microsoft, Google, Meta, Nvidia, Tesla and Amazon are up 100% on average. Everybody knows and loves these companies, so why not jump into the party up top? Maybe our pyramid analogy holds some insight into this dilemma.

IS THE STOCK MARKET TOP HEAVY?

Note that each peak was followed by a fall. After the bull market euphoria drives up a narrower and narrower group of favored stocks, the inevitable bear market correction levels out valuations. Usually it’s not by bringing up the valuations of the other stocks, but by bringing the top few down to earth. For now, we are in unprecedented territory with the top ten constituting over 32% of the S&P 500.

HOW DID WE GET HERE?

Are the 10 biggest companies that much better than the other 490? According to FactSet, the average Price to Earnings ratio of the top 10 is ~28 versus ~18 for the rest. They are certainly being priced like they are much better, and maybe they are, but there’s more to the story.

MARKET EUPHORIA

It’s possible, but history tells us unlikely. For one, things change over time. Companies come and go from the top for various reasons. Over the last 30 years, only 3 companies per decade maintained their spot. Just because it happened in the past, does not guarantee it repeats, but there are reasons to believe the trend will continue.

INDEXING

No doubt the popularity of investing in market indexes has contributed to these unprecedented valuations. As each dollar flows in, a larger and larger percentage of it goes to the same expensive stocks driving the index. As they get bigger the problem gets worse…until the pyramid becomes top heavy.

This creates a dilemma for investors. Even if a portfolio manager isn’t tasked with mimicking the index, the pressure to live up to its performance can be overwhelming. The longer it goes on, the harder it is for an investor to stick to their guns with lesser known but better priced growth and value stocks. It’s much easier to just jump on board and buy the index, rather than stay the course.

INTERNATIONAL GROWTH

Big-cap stocks benefit disproportionally from international trade and emerging markets have contributed to much of their recent profit growth. Apple exemplifies this with almost all its production, a majority of its sales, and its fastest growth coming from overseas. Other than domestic health care companies, it’s hard to find a big cap company that doesn’t have most of its manufacturing overseas, providing them low-cost products that they can sell to fast growing markets.

Sadly, the tide that lifted international trade over the last forty years is shifting. China, Russia, much of Latin America and the Far East were prime areas for growth not that many years ago. However, China is systematically destroying its growth model by persecuting its best entrepreneurs and siding with anti-American governments world-wide. While there are pockets of growth, many emerging markets are hurt by higher interest rates on their loans and worldwide conflict. Companies that built their business models on globalization, growing world trade and friendly markets, will struggle to see the same rate of growth and profitability return.

FREE MONEY

The challenge of being a big-cap stock is generating growth when you are already huge. One solution is to buy growth with cheap debt. Exxon is the only stock to stay in the top ten for twenty-five years not because they have been great at finding new oil and gas in the ground, but through buying new production one company at a time. Meta (Facebook) would be a fraction of its size without purchasing Instagram. In the last 7 years, Microsoft spent billions of dollars on LinkedIn (social media), Nuance (AI), GitHub (Software Development), and Activision (video games), allowing them to strengthen their business and expand into new markets.

In a recent newsletter we said that the days of free lunches were over. If you have tried to get a mortgage or car loan lately you understand that money is no longer “free”. Right now, the narrative is that this will mostly impact smaller companies, but big corporations are equally vulnerable. As the cost of capital increases, acquisitions become more expensive. Big companies also need to sell things to other companies. These companies are becoming more conservative with their investments as the flow of venture capital and private equity financing slows to a trickle. Less money in the system will impact everybody, big and small.

REGULATORY OVERSIGHT

Back when IBM was the biggest tech stock in the world, regulators were wary of its use of hardware, software, and service contracts to destroy the competition. After a long battle, regulators forced IBM to open their infrastructure to the broader computing industry. Eventually, new technology toppled IBM’s stranglehold. Today’s largest companies have been able to skirt meaningful regulations. Apple continues to demand 30% of revenue from its App store, to which there is no alternative. Amazon prioritizes in-house products, or you can pay them a fee (advertising) to move to the top of the webpage. Google pays Apple billions of dollars per year to remain the default search on the iPhone.

But now, it seems US and European regulators are no longer asleep at the wheel. If two struggling airlines, Jet Blue and Spirit, have to jump through hoops to pull off a merger, it’s clearly a sign of a changing regulatory regime. Not only are mergers going to cost more with higher interest rates, but they are going to be subject to more scrutiny. Anything deemed anticompetitive will have to battle an increasingly determined regulatory body. While the US justice system is messy, and we doubt there will be many “landmark” decisions that topple the giants, the changing climate could be just disruptive enough to allow an opening for new companies to thrive.

SUSTAINING VERUS DISRUPTIVE TECHNOLOGY

Twenty years ago, most data were held on servers owned by thousands of companies around the world. Today a handful of giants, Alphabet, Microsoft and Google keep most of that data in the cloud with only the very biggest making a profit. AI is expected to be an even more expensive market to enter and only profitable for companies with trillions in sales.

As expected, the Magnificent Seven jumped out to an early lead. Microsoft brilliantly skirted regulators by investing in OpenAI. Amazon and Google are leveraging their lead in cloud to help run the largest AI models. Meta is leveraging AI with more targeted advertising. Tesla’s self-driving claims would not be possible without AI. Therefore, the obvious conclusion is that AI is a sustaining technology that will just make the biggest even bigger.

We would point out again, that we have seen this movie. Before the tech bubble burst in 2000, the Internet was today’s AI. So much bandwidth was created that there was a glut for years. Cisco was going to grow to the moon on server sales, in the same way Nvidia will never experience a slowdown in GPU chip sales. However, the one constant in technology is that it is constantly changing. It will give you a great ride, but you better be able to get off the train before it crashes. The opportunity to innovate is tremendous, yet it’s becoming increasingly difficult to innovate at the top. At current valuations, the threat of disruption is not priced into big-cap stocks.

THE PRUDENT INVESTOR

There’s an old Wall Street saying: You will go broke betting against the market way before you are right.

So, the market is top heavy, but does that mean the current valuation landscape is predictive of an imminent bear market? We wish we knew! At a minimum, we don’t plan on going broke, but we can reduce risk of a potential fall by being much less dependent on the big-caps for good returns.

We are prudent investors who take our fiduciary responsibility to our clients seriously. We love the fact that our positions in stocks like Alphabet, Broadcom and Microsoft have been rewarded beyond our expectations, but despite the temptation, we will not mimic the market for the sake of short-term performance by making our portfolios top heavy.

We understand that prudent investing involves being able to avoid risk and that risk is highest when markets are most euphoric. We don’t think anybody has been or will be able to predict markets accurately enough to avoid risk by trading in and out. However, we do believe that when the market gives you a choice between overloading your portfolio with a small group of stocks priced to perfection alongside the rest of the market that is more reasonably priced, you should own more of the rest and not chase the chosen few.

COMPASS GROWS

We also know the importance of investing in high quality people. This fall we welcomed Emily Clare Cafasso to our growing team. In only a short period of time, Emily has had a remarkable impact on our client experience, and there’s much more to come! If you haven’t had a chance to speak with Emily yet, please don’t hesitate to give us a call. As part of hiring Emily, we’ve also expanded our presence into Fairfield County, CT with a new Westport office located at 164 Kings Highway North (Suite 1). If you are in the area, we’d love to have you by!

Wishing all our clients a wonderful holiday season.

Warmest wishes,
Your Compass Family

_{Compass Wealth Management LLC is a SEC registered investment advisor, clearing transactions primarily through Pershing Advisor Solutions and Pershing LLC subsidiaries of Bank of New York Mellon Corp. This letter is written by Compass for the benefit of its clients and does not necessarily represent the opinions of its affiliated organizations. It is based on information believed to be reliable, but which is not guaranteed to be correct. Nothing herein shall be construed to be a solicitation to buy or sell securities, indicate that past performance is predictive of future returns, or recommend individual investments.}