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Fellow investors,
The first half of 2024 is in the books, but it wasn't what it seemed.
U.S. stocks, as measured by the S&P 500, gained 15.3%, counting dividends. If you didn't own the whole market, though, you made a lot less. As you can see, cheaper stocks and smaller stocks fell behind the giants riding the artificial-intelligence boom:
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Wilshire.com
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And just as the biggest, growthiest stocks dominated the U.S. market, the U.S. crushed the rest of the world:
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The Wall Street Journal
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The MSCI ACWI index of roughly four dozen global markets including the U.S. was up roughly 11.5% in the first six months of 2024. Take out the U.S., though, and the rest of the world gained onlly half as much.
So while it may feel as if stocks as a whole have been on a tear, this market advance has been unusually narrow.
If you equally weight the S&P 500 -- treating the returns of smaller stocks the same as those of the bigger ones -- then the average company has gone just about nowhere over the past three years:
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Bespoke Investment Group
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Meanwhile, the stock market is nowhere near cheap on most historical measures:
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Strategas Research Partners
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It's always tempting, whenever markets seem to go to extremes, to try to bet on a return to normal.
But before you take drastic action out of fear of a sudden downturn, it pays to ask: What's "normal"?
Stocks are expensive -- but they've been expensive, relative to their long-term average, for more than three decades. The market is extremely concentrated, but not for the first time.
As the economist John Maynard Keynes didn't say, "The market can remain irrational longer than you can remain solvent."
That's why diversification is so important -- and why it requires so much patience that it can be painful.
Can Nvidia and other AI stocks keep outperforming everything else? Can big growth stocks dominate indefinitely? Can the U.S. continue to overpower the rest of the world's financial markets?
I suspect the answer to all three of those questions is No.
Eventually.
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At this point, everybody knows that the U.S. stock market is heavily concentrated in a handful of tech giants, with nearly 29% of the S&P 500's total market value made up by only five companies: Microsoft, Nvidia, Apple, Google's parent Alphabet and Amazon.com.
I think diversifiying is vital, in case that dominance dwindles.
But how much should we worry about something everybody is worrying about? By definition, common knowledge is already in the market price.
As Michael Mauboussin and Dan Callahan of Morgan Stanley showed in a recent report, concentration has risen -- but talk of "record highs" is overblown:
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Morgan Stanley
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Global Financial Data, a firm specializing in historical research, went all the way back to 1790, plotting the percentage of total U.S. stock-market value attributable to the 10 biggest stocks, the five biggest, and the single largest of all.
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Global Financial Data
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On this extended time scale, the recent surge is just a blip.
Of course, the evidence from the days of horse-drawn carriages and whale-oil lamps, when the U.S. was an emerging market with dozens of regional stock exchanges, isn't that relevant to today's landscape, where billions of dollars in spending on AI seems likely to make the biggest companies even bigger.
But one thing is relevant: All the way back to about 1850, whenever the top 10 companies made up more than 30% of total U.S. stock-market value, that concentration turned out to be unsustainable.
The top 10 make up almost 37% of the S&P's total capitalization now. History suggests that's more likely to shrink than grow.
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Elephant fighting a lion (India, ca. 1770), National Museum, New Delhi, via Wikimedia Commons
The bigger they are, the harder they fall.
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What's your biggest investment? Do you think it's gotten too big, and what, if anything, do you plan to do about it?
To share your thoughts, just reply to this email. Responses may be edited for brevity and clarity. Please include your name and location.
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"David and Goliath," detail from the Crohin-La Fontaine Hours (Belgium, ca. 1480), Getty Museum
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Mary Cassatt, "The Letter" (ca. 1890), Art Institute of Chicago
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Have a question you'd like me to answer?
Want to weigh in on what you just read? Got a tip on something that I or my colleagues should investigate? Itching to tell me I'm wrong about something?
Just reply to this email and I'll see your note. Don't forget to include your name and city.
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Q:
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I recently came across "What Goes Up" in Harper's by Andrew Lipstein. This article gave me concern for the long-term prospects of index investing and the "system" overall.
A couple of quotes stood out:
"When a stock’s price increases, it gets an even bigger piece of every new dollar invested in an index it’s a part of (assuming that index is market-cap weighted, as most are)—which, of course, only helps to push the price up more...it’s inevitable: at some point in the future, net flows will become negative. The passive-investing market will be, more or less, a roller coaster gliding over its crest. What then?"
With a rapidly aging population is there legitimate reason to be concerned that one day net cash flows into index funds will be negative, which could set off a mass selling event?
— Chase Koch, Des Moines
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A:
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For decades, the managers of active funds, who pick stocks for a living, have claimed that index funds are forced to buy more of whichever investments go up the most. "The more a stock goes up, the more the index funds have to buy it," is the refrain.
That isn't true.
Imagine the entire stock market consists of only two stocks: Costly Corp. and Cheapo Inc. Costly is extremely expensive, trading at 50 times its earnings over the past 12 months; Cheapo is cheap, trading at only 12.5 times its earnings over the past year.
Costly makes up 80% of the total value of the market; Cheapo is 20%.
Therefore, the VanRock Total Stock Market Index Fund has 80% of its money in Costly and 20% in Cheapo.
With $10 billion in assets, the index fund has $8 billion in Costly and $2 billion in Cheapo.
Now imagine investors pour another $10 billion into the index fund. What will VanRock do? It will buy $8 billion more of Costly and $2 billion more of Cheapo -- resulting in a $16 billion Costly position and a $4 billion Cheapo holding.
The index fund started with 80% of its money in the expensive stock and 20% in the cheap one, and that's exactly where it ends up -- even after it doubles in size.
The index fund does not buy a disproportionate amount of the expensive stock; its prospectus and its structure require it to buy (or sell) enough of each holding to keep their relative weightings constant.
What if investors yank $10 billion right back out? Then VanRock will sell $8 billion of Costly and $2 billion of Cheapo, ending up right back where it started.
Just as VanRock didn't increase the relative size of its holding of the more expensive stock on the way up, it doesn't decrease it on the way down.
The index fund always matches the market weights of its holdings -- which are determined by active stock pickers, not by index funds.
As I recently highlighted, active ETFs can lead to "self-inflated returns," in which new money from investors drives up the prices of a fund's holdings, attracting still more new money, which in turn drives the underlying stocks up higher.
But I see no evidence that passive funds have caused (or are likely to cause) a similar effect. They track the market; they don't hijack the market.
As I once wrote:
If index funds cause market bubbles, they’re not nearly as good at it as human beings are. Why should we be more afraid of index funds causing a bubble today than anybody was of active investors causing one in 1999 or 1972 or 1929? The Panic of 1907, the Panic of 1873, the Panic of 1857, the Panic of 1837, the crash of 1792 and the pan-European bubble of 1720 were all inflamed by human stock-pickers long before the idea of an index fund had ever occurred to anybody.
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Be well and invest well,
Jason
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Anna Ancher, "Harvesters" (Denmark, 1905), Skagens Museum via Wikimedia Commons
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It is undoubtedly better to concentrate on one stock that you know is going to prove highly profitable, rather than dilute your results to a mediocre figure, merely for diversification’s sake. But this is not done, because it cannot be done dependably.
—Benjamin Graham, The Intelligent Investor
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