The Five Stocks Driving the Market in 2023

Episode Summary

Executive Summary: The episode argues that major U.S. stock indices are becoming increasingly concentrated in a handful of mega-cap tech stocks, especially Apple, Microsoft, Nvidia, Alphabet, Amazon, Tesla, and Meta. While this raises diversification concerns for index investors and regulatory issues for fund classification, the host contends the situation is more grounded in profits and fundamentals than the dot-com bubble, though valuation and crowding risks remain.

Main Topics: Index funds and the changing role of stock indices (Priority: 5/5): Explains how indices evolved from market barometers to investable products for index funds, and how the rise of passive investing has changed their purpose. Concentration in the S&P 500 (Priority: 5/5): Details how a small number of mega-cap tech stocks are driving most of the index’s gains and earnings growth, reducing effective diversification. Nasdaq 100 concentration and regulatory rebalancing (Priority: 5/5): Shows that Nasdaq 100 concentration became so extreme that Nasdaq conducted a special rebalance to preserve fund-diversification compliance. Comparison with the dot-com bubble (Priority: 4/5): Argues that today’s tech concentration is not the same as 1999 because current leaders are far more profitable and valuations, while high, are less extreme than during the bubble. AI, ESG, and profits as drivers of tech leadership (Priority: 4/5): Attributes much of the recent tech rally to generative AI enthusiasm, ESG-driven sector flows, and the strong profitability/cost discipline of the leading tech firms. Investment takeaways and alternatives (Priority: 4/5): Suggests investors avoid chasing hot sectors, notes that equal-weighted indexes offer more diversification but with higher volatility and tax costs.

Key Arguments: Index funds are excellent long-term vehicles, but the diversification they provide is weakening as market-cap weighting concentrates exposure in the largest stocks. The S&P 500’s year-to-date gains are heavily dependent on a small group of mega-cap tech names, while the rest of the index is roughly flat. The current concentration is less about irrational valuation than about real earnings power; tech valuations are elevated but not near the extremes of the dot-com era. Nasdaq had to rebalance because its largest constituents exceeded the diversification thresholds needed for mutual-fund classification. AI excitement and ESG flows have amplified the dominance of large tech companies, but profitability remains the key reason they dominate the indices. Equal-weighted indices can reduce concentration risk and sometimes outperform, but they do so with higher volatility and lower tax efficiency. Chasing the best-performing sectors is risky because leadership often reverses over time, so a steady long-term approach is preferable.

Data Points: Index fund market share: 20-30% of the American equities market - Passive/index funds now control a very large share of U.S. equities. S&P 500 year-to-date return: around 19% - Described as a strong year for the index, though driven by a narrow group of stocks. Mega-cap stock contributors: 7 stocks - Apple, Microsoft, Alphabet, Amazon, Nvidia, Tesla, and Meta drove most of the S&P 500’s gains. Year-to-date gains of the top seven: 35% to 210% - These stocks had surged far more than the rest of the index. S&P 500 technology weight: 28.1% - Current weight of the technology sector in the S&P 500. S&P 500 technology weight including Tesla as tech: 29.9% - Alternative weighting if Tesla is classified as a technology company. Top five S&P 500 stocks weight: nearly 25% - Apple, Microsoft, Amazon, Nvidia, and Alphabet represent nearly a quarter of the index. Top five weight at dot-com peak: 16% - For comparison, the most concentrated names were less dominant at the 1999 peak. Apple market cap: $3 trillion - Used to illustrate Apple’s scale relative to smaller-cap indices and the UK market. Apple weight in S&P 500: 7.6% - Apple alone represents a very large share of the market-cap weighted index. Tech sector first exceeded 25% weight: February 2018 - Marked the first time since the dot-com era that tech exceeded a quarter of the S&P 500. Forward P/E for tech sector: a little over 27 - Used to show valuations are high but below the dot-com peak. Dot-com peak P/E for tech sector: 60 - March 2000 valuation peak for comparison. Expected S&P 500 Q4 2023 earnings growth: 8.2% - FactSet estimate for index earnings growth. Earnings growth contribution from four companies: 4 percentage points - Meta, Nvidia, Alphabet, and Amazon accounted for half of expected growth. Remaining S&P 500 earnings growth without those four: 4.2% - Illustrates the narrowness of index-level earnings growth. Nasdaq 100 tech share: 57% - People view it as a tech index, but its official composition is broader. Nasdaq 100 tech share including Tesla: just over 60% - If Tesla is counted as tech, the technology weight rises further. Apple weight in Nasdaq 100: 11.7% - Shows individual-company concentration within Nasdaq 100. Microsoft weight in Nasdaq 100: 9.4% - Another major concentration in the index. Combined weight of six largest Nasdaq names: 50.5% - Microsoft, Apple, Alphabet, Nvidia, Amazon, and Tesla crossed the diversification threshold. MSCI global value stocks performance: down about 12% - Highlights the weakness of value investing relative to growth/tech. ARC Innovation Fund performance vs peak: 68% below its 2021 top - Used to contrast unprofitable speculative stocks with profitable Nasdaq leaders. ARC capital in profitless enterprises: 82% - Shows the speculative nature of the fund compared with the Nasdaq 100. Nasdaq 100 weight in profit-generating companies: 99.5% - Supports the argument that current mega-cap leaders are fundamentally profitable. Equal-weight S&P 500 volatility: 10% more volatile than regular S&P - Tradeoff for greater diversification. NVIDIA market-cap gain in 2023: $640 billion - Illustrates the magnitude of the AI-driven rally. Tesla valuation: around 10x revenues - Compared with Sun Microsystems’ extreme dot-com-era valuation. NVIDIA valuation: around 44x revenues - Suggests high but still monetized market enthusiasm.

Pivotal Quotes: "The problem with the dot-com era was that stock valuations had exploded beyond reason, not that the market was too concentrated." — Patrick Boyle: Used to distinguish today’s concentration from the late-1990s bubble. "At 10 times revenues, to give you a 10-year payback, I have to pay you 100% of revenues for 10 straight years in dividends." — Scott McNeely: Quoted to illustrate how absurd peak dot-com valuations were. "The takeaway is possibly that investors should plot a steady course and avoid chasing market trends or getting too carried away with the hype stocks of any given moment." — Patrick Boyle: Summarizes the episode’s practical investing advice.

Implications: Index investing remains useful, but investors should recognize that cap-weighted funds can become dominated by a few stocks. Diversification, valuations, taxes, and volatility matter more when index leadership is so narrow.