Sometimes being top heavy can have very negative consequences. If your vehicle is top heavy, the laws of physics are unkind when making sudden directional changes. Being top heavy increases the odds of tipping over.
Sometimes being top heavy prevents an organization from reaching peak performance. If a company has more people working at the management level than actually providing services or building products, it is likely time to trim back on the managerial ranks to improve the company’s efficiency and financials.
And sometimes being top heavy is really, really beneficial. This year’s stock market index returns are a perfect example of this. When financial gurus create an index they have several different methods for constructing it.
The archaic Dow Jones Industrial Average is a price-weighted index. As the name would suggest, it is calculated using the share price of the 30 stocks that it includes. This is generally viewed as an inferior index methodology.
Index creators could also choose to make an index equal-weighted. This means that each stock included in the index has the same weighting. If there are 50 stocks, then each one would make up 2% of the index. This provides a broad sampling of markets.
The most common indices (S&P indices and Russell indices) are cap-weighted. Cap weighting gives more weight to the largest companies in an index.
For example, assume the total market value of all companies in an index is $1,000. If Company A is included in the index and its market value is $200, then it would make up 20% of the index ($200 of the $1,000 value). Thus, if Company A’s market value (number of shares times share price) went up by 10%, it would move the index up by 2% (20% weighting times 10% gain).
Similarly, if Company B is included in the index and its market value is only $10, then it would make up a mere 1% of the index. Thus, if Company B’s market value went up by the same 10% as Company A, it would move the index up by a measly .1% (1% weighting times 10% gain).
So far this year, the 5 largest companies in the S&P 500 Index have seen rather astounding increases in their market values:
- Company 1 — has an index weighting of 7.44% and YTD return as of July 17, 2023, of +49.67%
- Company 2 — 6.76% weighting and +44.73% YTD return
- Company 3 – 3.16% weighting and +59.00% YTD return
- Company 4 – 2.96% weighting and +217.98% YTD return
- Company 5 – 2.00% weighting and +135.74% YTD return
Combined, these heavily-weighted five companies have contributed roughly 17.75% of return so far this year for the top-heavy S&P 500 Index.
The lesser-weighted remaining 495 companies in the S&P 500 have contributed a grand total of 1.1% to the S&P 500’s total return so far this year. This is the definition of a top-heavy market that is susceptible to the laws of physics.
As always, the future is unknowable and past performance is no indication of future results. However, there are two simple ways to correct a top-heavy market.
Option 1 is for the lesser-weighted 495 stocks to catch up with the top-heavy stocks. This would bode well for future stock returns. Option 2 is for the top-heavy stocks to stumble back to the pack. If I had to guess (and it is only a guess) at which option is more likely heading into uncertain economic times, I would have to guess option 2.
However, the market has never been very good at doing what I expect over very short periods of time. Perhaps, just to personally spite me, these heavily-weighted stocks will continue their upward trajectory indefinitely. I would find that acceptable as that would benefit our clients.
On the other hand, if the top-heavy markets struggle for a bit to restore some normalcy, I would gladly accept that as well because we have time on our side.
Successful investors humbly accept their inability to predict future returns and focus their efforts on aligning their portfolio risk with their short- and long-term financial plans. If you know someone you care about who would benefit from such an approach, please share us with them.
Quote of the week: Shane Parrish: “Impatience causes more problems than stupidity.”
