Why the Stock Market Might Be at Peak Concentration Risk

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1:52Hello and welcome to another episode of the Oddbots podcast. I'm Tracy Alloway. And I'm Joe Weisenthal. Joe, do you remember when you first heard the term MAG7? You know, I don't, if I'm being honest, but you know, these acronyms for big tech stocks, like they kind of, you know, people used to talk about FAANG, right? I know. I was just thinking that. Like when did the handoff from FAANG to MAG7 actually happen? We need to do one of those like Google Trends, Engram things. That's a good question. And then there was like FANG plus and then FAMG. But they're all kind of the same thing. It's just big tech stocks.

2:31Right. So the terminology, the acronyms might change. But I think the subject is always kind of the same and the concern is always the same. It's this idea that there is like a handful of big companies, usually tech stocks, that are driving the entire market. Yeah. And it drives people crazy, right? They're so big. And they've grown so much. And the stocks have done so well over the years. And all these old strategies of like, oh, we're going to like buy cheap or buy cheap, low book value, you know, price to book. And all these traditional investing patterns, it never mean reverts. For years and years and years, except for like five minutes in 2022, they just go straight up.

3:14And the only test of whether you're a good investor or not is whether you're overweight. Whether you bought 10. Yeah, that's it. That's it. That really is the alpha nowadays. But, you know, you see these numbers thrown around like I think Goldman Sachs said that the top 10 stocks now account for something like 38 percent of the S &P 500, which is a record. Yeah. And seems quite a lot on the face of it. And I saw another number out there saying 26 stocks now account for half of the entire value of the S &P 500. So I think it brings up a bunch of interesting questions. How bad is the concentration?

3:52Is it intrinsically bad in and of itself? Is it actually that risky? And also, how are financial professionals and the market itself actually reacting to this concentration risk? So I think we should talk about it. Totally. You know, I look at myself in the mirror and I say to myself. Do you point at yourself like that meme? On some days I point and say, you're a good, because, you know, I'm just like a boring index fund investor from my retirement, you know. So I point and say, oh, you're a good investor because you've been really long tech. And then on other days I wake up and say, oh, you are really heavily exposed to 26 stocks.

4:30And so, you know, it's like to, you know, glass half full. It's like good, but also makes me a little anxious. You shouldn't take credit. You should give that credit to S &P. Thank you. And then when the market collapses, you should blame them. I do. I say thank you to the wonderful fund managers at S &P. I only wish you hadn't, you know, every once in a while they have a dud. It's like, why'd you pick that one? Anyway. Or why didn't you include Tesla? Yeah, right. Exactly. All right. Well, without further ado, we do in fact have the perfect guest for this topic, someone that I've wanted to speak to for a long time.

5:03And I can't believe we haven't had him on the podcast before. major oversight on our part. We're going to be speaking with Kevin Muir. He is, of course, the macro tourist and a longtime voice on Fintwit and writing on his blog as well. So Kevin, thank you so much for coming on All Thoughts. It's great to be here. Thanks, Joe and Tracy. Maybe just to begin with, it's the first time you're on the show. I've always sort of known you as this voice that's hanging around in the finance blogosphere. But what's your background? So I was the equity derivative, institutional equity derivative trader at RBC Dominion Securities in the 90s.

5:44I was kind of at the forefront of the technological boom and the automated trading and the index trading and the taking off of all these index products. And then in 2000, I actually went off on my own and I thought maybe, you know, I'll go work for a hedge fund. And I thought, well, at the same time, I can go and trade for myself for a little bit and see how that goes. And that's kind of 25 years later, and I'm still doing it. You write The Macro Tourist. What's your goal? What do you, for those, we're both big fans of your writing, but what do you like to write about? What's your sort of goal with your writing?

6:20Well, Joe, it originally started off as a diary. And I just kind of, good traders, you're supposed to keep a diary. And I would start writing things. And then people would phone me up and ask me what I thought of the market. And I would send it off. And to them, I would just go, well, here's what I wrote in my diary. Eventually, they started to ask often enough that we just started to put it up on the net. And then it took off from there. And from there, I ended up going and actually started my podcast and meeting all sorts of people. And one of the kind of just great parts about being on the podcast is the fabulous people I got to meet.

6:54Along the way, I meet people like Jim Leitner, and I've had Mike Masters on the podcast. And those people are market wizards. They're terrific. And I get to share ideas with them. And it's just I consider myself one of the luckiest guys in the world. So let's get to the topic at hand then. Give us some context around concentration risk in something like the S &P 500 right now. I threw out some numbers earlier, but how extensive is this concentration and should we be worried about it? Well, Tracy, one of the things that people will kind of push back on when you say that the U.S. has become more concentrated, is they'll say things like, oh, but if you go look at other indexes around the world, they're also very concentrated.

7:36And that's absolutely correct. There's no doubt about it. This is something that is experienced in Canada. As I mentioned, I'm a Canadian and I was on the index desk at a time when Nortel was actually 35 % of the entire index. So if you think that you guys were having trouble dealing with this now, just imagine having 35 % of the index being one stock. It was actually even worse than that because we had kind of a palm at Triple M situation where Bell Canada was one of our next biggest stocks and it main holding was all of its Nortel holding. So it ended up being that the index managers were stuck because if you think about it from a fiduciary point of view, it doesn't make sense to have 50 % of your portfolio, you know, exposed to one stock.

8:24It's risky. And so one of the things that I'm hearing now when you bring up the problems about concentration risk in the U.S. is they'll say, oh, no, but don't worry. It's actually much better than the rest of the world. And I won't deny that for a second. But isn't that kind of like saying, you know, my Mercedes is now using plastic knobs, but don't worry. The Honda uses plastic knobs, too. Part of the reason that investors have been attracted to the U.S. is that it is a diversified basket of many stocks. And just think about, you know, Warren Buffett. Warren Buffett tells you you can buy the S &P 500, you can sleep at night.

9:02But if you go and talk to investment advisors around the world and you ask them, do you think your clients really, truly know what's underlying that basket? I think most of them would say they would assume that it's roughly equal weight. And they would be shocked to learn that, you know, Microsoft, NVIDIA, Apple are each almost 7 % of their basket for a total of 21%. And so it ends up being, it's a worrisome kind of new development in the U.S. And I don't buy the argument that just because other countries are more, you know, concentrated that we shouldn't worry about it in the U.S. And all you have to do is look, Tracy, you mentioned that Goldman Sachs stat.

9:42And they have another one that they published and they went back and they looked at concentration risk throughout the last century. And if you look at it, we are now just as concentrated as we were right in front of the Great Depression in 1929, in the nifty 50, in the early 70s, and the dot-com bubble in the late 90s. Well, all those times were not good times to buy stocks for forward returns. So increasingly, I think that we need to be aware that this is a risk. And there's more and more conversation happening around that.

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11:17In addition to all that variety, EasyCater also gives you full visibility of your organization's food spend with invoicing, centralized reporting, and seamless integration with expense management systems, all on one platform. Easy Cater, your business tool for food. To learn more, visit easycater.com slash podcast. I'm happy that NVIDIA has been 7 % or somewhere south of that in my portfolio. I didn't even have to do anything. And I made a big allocation to one of the best performing stocks in the world. And not only that, I mean, I take your point about concentration and et cetera, and obviously very alarming.

12:00These are also account for a huge share of the actual earnings, too. So, I mean, one, you know, there was a lot of concentration in 99, 2000 with tech, but a lot of those companies weren't really making that much money. These companies are earnings juggernauts. Well, no doubt. You're absolutely correct, Joe. And that's kind of the pushback to this argument that we're concentrated world. They'll say, oh, it's bank seven. It's a wide variety of different companies that do different things. It's not like it's all one industry. And not only that, the valuations aren't as crazy as they might seem. No doubt about it.

12:36You can make that argument. But let's just imagine tomorrow that the AI bubble doesn't live up to its hype. Let's imagine that all of a sudden we have some sort of earning surprise and these stocks get halved. It's not that hard to imagine. We went through it in 2022. So if that occurs, I think that people will be quite shocked at how their supposedly diversified basket of stocks performs. And more importantly than that is that we can sit around and we can debate whether you should own this or whether this is prudent. but more and more fiduciaries, more and more risk managers, more and more institutional portfolio managers are looking at it and saying, this is dangerous and they're looking for ways around it.

13:25And one of the things that many of these managers are bumping up against is that although the S &P 500 is actually in line with this following rule of this thing called the 25-5-50, which means that no one stock can have more than 25%, and the biggest stocks that are over 5 % can't add up to more than 50 % of your portfolio, that's an IRS rule that is called the 25-550 rule. There's no problem with the S &P 500 currently with that rule. But there is something called the Russell 1000 Growth Index. And increasingly, more and more institutional managers are benched to that index. And what we're seeing is within that index, we're bumping up against that.

14:15And what's happened now is that Russell has realized that this isn't just kind of a fiduciary point of view. This is actually an IRS issue in terms of they cannot go over those things. So what we're seeing is there's changes in the rules coming to make sure that this index is capped. By the way, Tracy, Kevin mentioning how exposed everyone is to AI beta, so to speak. And I just want to give a plug. We had a really good contribution in the Odd Lots newsletter from Skanda recently on this whole thing. There's just both in stocks and the economy and the real economy. There's just this like we get they better get this thing right.

14:59Yeah, seems kind of important. Kevin, you mentioned finance professionals reacting to this concentration risk. So, OK, maybe your average mom and pop retail investor doesn't realize that the S &P 500 is not, you know, 500 equal weighted stocks. But certainly finance professionals do. And they're aware of both the risk involved in having a large concentration in just a handful of stocks and also some of the requirements around diversification. diversification, so legal requirements that you just mentioned. Before we get into some of those changes, can you maybe just give us a little bit of background on the importance of the index providers to the finance industry itself?

15:45This is sort of a pet topic of mine that I've written about occasionally, but how big a deal are the index providers now? Well, you're absolutely right to highlight that, Tracy. And I'm glad to see you have such an enthusiastic attraction to index providers. I'm the only one. You're the only one that gets excited about it. But it is a big story. And one of the issues is that as indexing has become more popular, some of the kind of traditional, the first of the indexers have started charging more, which has created an an opportunity for other index providers to jump into the loop. So obviously, we all know the S &P 500, but then there's the FTSE, which is Russell.

16:30But there's also things like Morningstar and even you guys at Bloomberg have a lot of great indexes and you're competing on a lot of these things as well. So what's driving that is kind of two factors. One of them is that there is the cost associated with the big ones. So they're just trying to clients that have to pay tens and hundreds of thousand dollars for this index data is our changing providers trying to get something cheaper. And then the other thing is, is a little more kind of nefarious. There's some indexes that are easier to beat. So if you have an index that you know the rules, you can actually front run them.

17:09One of the, when I was researching this and learning about this, someone told me that It's important that you buy the products of the indexes that are difficult to beat. And then from a kind of client perspective, you choose, if you are a portfolio manager, you choose the indexes that are easier to beat. Because if you're using, you know, for example, the S &P 500 as your benchmark, that's a lot more difficult to beat than another index that might have one annual revision that is easy to kind of forecast. and run ahead of. Joe, I should just mention, Kevin was kind enough just then because he's a very polite Canadian to basically do our disclaimer for us, which is that Bloomberg LP, the parent company of Bloomberg News, does own a bunch of different indices, but probably most prominent among them are the Bloomberg Bond indices, and those were the Barclays indices before.

18:09So I should just mention that. There you go. Thank you, Kevin. and thank you. Can I jump in with just a little pro tip since a lot of people are getting Bloomberg users? One of the things is if you go and you want to see, for example, the index move in the S &P 500 and you type in HMOV, you'll see that they actually, unless you pay for that data, you don't get the index point changes. But Bloomberg has the B500, which is very similar and you can plot it in and then all that functionality that you have to pay for on the other things, it actually works quite well on the Bloomberg indices. There you go.

18:45So if you have a Bloomberg terminal, but don't feel like paying for the S &P data specifically, Kevin just gave you a little bit of alpha there. But you know, it actually, you talked about a front running index changes. Why is it that easier, right? Like S &P, they announced, oh, some new company is joining an index. How can you make money from those announcements? Well, you used to be able to. There was a huge opportunity before, and there was hedge funds that devoted themselves to doing it. But now everyone knows the ones that are, you know, due to go in. And then there's hedge funds who actually have portfolios of all the stocks that are due to go in.

19:23And even not just hedge funds, even pension funds will go out and front run them because they realize that there's some alpha there. So at the end of the day, Joe, the problem is that the more people look at it, the less money there is to be made in kind of trying to guess those things. All right. So let's get into how not just the benchmark index providers are reacting to increased concentration, but also how finance professionals are. You mentioned the Russell 1000. So give us a little bit more detail on what's happening there. So Russell 1000 is aware that there's intense concentration risk.

19:59Right. So they're jumping. So they're actually getting ahead of their problems of potentially going and bumping up against this 25-5-50 rule. And for those who aren't aware of it, this isn't a new phenomenon. We actually had this in the summer of 2023 when Microsoft became too large of a position within the QQQs and there needed to be an emergency rebalance where they reduced the size of Microsoft. And then we also saw this in the Sector Select XLK Spider, where NVIDIA ran up and it actually ended up again, we bumped up against that 25-550 rule, and there needed to be an emergency rebalancing there.

20:44And that was a situation where there was the way that their capping worked. It was this kind of very violent shift from selling Apple and buying NVIDIA. And then kind of the next quarter flipped the other way because of the way that the stock prices moved. And they had to do this rebalance again the other way. And so this is the problem with that that many of these index providers are kind of bumping up against in terms of they don't want to be too violent with their shifts. They don't want to go and get into situations where they're rebalancing all the time, trying to keep within this limits.

21:20And that is why the Russell in this R1000 growth, which is one of the most popular growth indexes out there, they chose instead of using the 5 and the 50 rule, they used 4.5 and 45. Meaning that any stock above 4.5, if all those stocks add up to 45%, then they do this rebalance. so they've kind of given themselves a little bit of extra you know room there in terms of the rebalance what's interesting is that they had announced this i don't know it's a year ago because they saw this problem coming nobody was talking about it oh yeah i actually went back to try to find articles on this i couldn't find any yeah the way that i came upon this this idea and this this kind of revelation about that this is coming up was actually one of my subscribers and a buddy sent me something from Kevin Che from Discipline Alpha.

22:14And he'd written this whole piece about it and just highlighting it. And one of the reasons that he highlighted is he was a mid-cap manager during the 2000s. And he distinctly remembers Siebel Systems and another one. I can't remember the other one, but there was two big stocks in the S &P 400 that were due to go into the S &P 500. And when they did it, the trouble was that the guys that all bought it for the S &P 500. And then when the S &P 400 guys went to sell it, there was no bids. And that coincided with the top of the NASDAQ market. And he's very kind of adamant that this could be another situation where we have a situation where the MAG7 has to go down in weighting.

23:04In one of the biggest indexes out there in terms of after the S &P 500, this is probably the next biggest growth index out there. And when this rebalance occurs, which again is in March, ironically, it's the same deal. There's going to be millions and millions of shares of these MAG7s for sale. And so for me, when I was trying to learn about it, I went and said, okay, I went to an old buddy at TD and they were one of the few, and I think he said he was the first sell-side dealer to actually start talking about this. But increasingly over the last month, there's been more and more folks paying attention and realizing that this is a bigger deal than they realize.

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25:21Brokerage services for U.S.-listed registered securities, options and bonds, and a self-directed account are offered by Public Investing, Inc. Member FINRA and SIPC. Crypto trading provided by Backed Crypto Solutions, LLC. Complete disclosures available at public.com. By the way, as Tracy knows, I love.com era trivia and talking about that. And so like you talk about Siebel and you talking about the three com palm situation and all these are like these are some of my catnip. Yeah, this is a total catnip. You know, it occurs to me like the sort of the very strict Chicago school. There's no such thing.

26:00Everyone. People love to say there's no such thing as like you can't as passive investing. You can sort of get close to it. And the strict Chicago school people is like, you buy the global market portfolio at their market value, every investable asset in the world. These rules essentially make it impossible, right? Because if you had some stock that was, I don't know, got so big it was 25 % of the index or whatever, but you're not allowed to do it. Technically, you really couldn't buy the true market portfolio given some of these constraints. That's correct. And that's an IRS constraint. And then not only that, just stop and think about if you go and you try to recreate these portfolios at a broker.

26:44I spoke to one investment advisor. He said, if I went and made a portfolio of the QQQs, like if I just made it from scratch and did all those things, that compliance would tell me that I'm too concentrated in tech stocks. So he says, I'm not allowed to buy this from a compliance point of view, but I'm allowed to buy the client's QQQs. and that's back to my point is that we all just kind of been lulled into this feeling that everything's okay it's it's a it's a broad index and it's no longer as broad and ironically you're talking about this idea about the mark the indexing and if you remember mike green and his theory that the big will get bigger because of indexing and more and more people will just continue and this will create a situation where the biggest stocks will continue to get bigger and bigger and bigger.