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The Truth: Your S&P 500 ETF Is Riskier Than You Realize

In this article, I’ll be talking about the extreme concentration driving the S&P 500 index and the five mega-tech stocks that have given rise to the index’s forbidding valuation. I’ll also be letting you know about enticing value stocks that can reduce portfolio risk and diversify your portfolio away from market-cap-weighted ETFs benchmarked to the S&P 500.

Quant Value Picks Offer Better Value And Growth Vs. Mega-Tech Stocks

Apple (NASDAQ:AAPL), Microsoft (NASDAQ:MSFT), Amazon (NASDAQ:AMZN), Facebook (NASDAQ:FB), and Alphabet (NASDAQ:GOOG) (NASDAQ:GOOGL) now comprise 25% of the market capitalization of the S&P 500 Index. Per Russell Investments, “It is far and away the most concentrated market in the data spanning the last 40 years.” This clustering means the index’s performance is being steered by just a handful of stocks. These five mega-tech growth stocks are now dominating the S&P 500 index, and many other high-profile strategists agree with this sentiment. An old friend, Mike Wilson, Head of Strategy at Morgan Stanley, says, “Only 30% of the S&P 500 constituents outperformed the index in August … the lowest percentage since 2000.” This backdrop should serve as a stark warning to anyone holding a market-cap-weighted ETF benchmarked to S&P 500 Index.

What Drove the Market Rebound from March Coronavirus Lows

The market was expecting a strong rebound in earnings.

We witnessed unprecedented monetary and fiscal stimulation.

Near-zero interest rates fueled an exodus from bonds to stocks.

In March and April, as the coronavirus was peaking, the market started to rebound from its COVID-19 bottom. The rally was ignited by massive government stimulus and anticipation of a strong earnings rebound. The market is a leading indicator, and investors were factoring in expectations that the second half of 2020 and first half of 2021 would show signs of economic recovery. Helping to fuel that sentiment was the unprecedented level of monetary and fiscal stimulus being injected into the economic system from developed countries around the world. On the back of monetary stimulus, and with interest rates set at near zero, we witnessed a massive migration out of bonds and into stocks. This fresh capital helped fire up a rocket-like rally. And the immediate benefactors of this capital were safe-haven mega-tech growth stocks.

With expectations already very high, any setback to the recovery could deliver a heavy blow to the large-cap heavyweight stocks that have been driving the S&P 500. So as markets begin to stabilize, investors should start to broaden out their positions.

… And What Led the S&P 500 to Such Extraordinary Valuations

The top-line performance for the index is misleading, as it papers over the broader market return. On an absolute basis, only 26% of the stocks in the S&P 500 exceeded the index’s overall return; 74% have underperformed year to date. By another measure, 60% of the stocks in the S&P 500 had a negative return since the start of 2020. According to Yana Barton of Eaton Vance Management, “Year to date, the average stock is down 3%.”

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The over-stretched performance of this small band of stocks has also led to an extraordinarily high valuation by historical standards. The current P/E ratio (price/diluted EPS excluding extraordinary Items) of the S&P 500 stands at 33.7x vs. the 20-year historical average at 23.4x. While it may not necessarily echo the “irrational exuberance” era of 2002, it does highlight the fact that the market is pricey per traditional fundamental standards. Notably, the best-performing stocks sport some of the richest valuations.

September’s Correction: A Systemic Signal or a Technical Pullback?

September’s market correction has confirmed the market was overheated in August: Mega-tech and momentum stocks took a haircut at the beginning of the month, and investor behavior overall points in the direction of a technical pullback. Importantly, the correction saw a rotation to both cyclical stocks and coronavirus underperformers. This rotation confirmed that the catalysts behind the correction were not a systemic economic problem. In the short term, it appears there are more valid reasons for uneasiness here than for rationalism to spark another record-breaking rally:

In just a matter of weeks, Americans vote to decide who controls the White House and Senate. Notably, election night may become election month.

Both monetary and fiscal stimulus are baked into the market.

Optimism is fading for a Christmas COVID-19 vaccination. The U.S. may also be facing a fall/winter virus surge as students go back to school and employees return to the office.

Mega-tech stocks with elevated fiscal first-half sales trends, having benefited from outsize market share through the pandemic, could decelerate into the second half of this year and the first half of 2021.

The biggest concern or source of uncertainty is, hands down, the upcoming U.S. election. In less than two months, Americans will vote to decide who controls the White House and the Senate, and COVID-19 has ushered in an unprecedented era in American history in which folks are being prompted by local government to mail in their ballots. The Brookings Institute in Washington, D.C., is estimating that “at least half if not more of all ballots cast in November will be by mail or via early voting.” Investors need to prepare to wait beyond Election Day for a final result, as increased use of mail-in voting could slow down counting, and markets could struggle to price in a policy path for the next four years. Typically, equity markets do not like uncertainty – and investors respond with downward selling pressure or, at minimum, they wait on the sidelines.

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Half of Americans Fear Difficulties Voting In November Elections – Poll by Pew Research

red and white textile on white ceramic plate

Source: Tiffany Terpites/Unsplash.com

As Jon Snow from Game of Thrones often said, “Winter is coming!” An additional weight on the market is that it looks like there won’t be a coronavirus vaccination, in critical mass, during this calendar year. Optimism for a Christmas COVID-19 vaccination is fading and the U.S. may also be facing a fall and winter virus surge as students return to school. It is also becoming apparent that sick college students are being sent back home to their local communities. NIAID Director Dr. Anthony Fauci warned colleges, “If at all possible, do not send students home … It’s the worst thing you could do.”

It is also fair to mention that the shine on economic stimulus policies may be losing a bit of luster. The enormous monetary and fiscal stimulus bailout packages have largely been discounted by investors. The positive impact of stimulus packages has been factored into the markets since April. Additionally, it is well known that the Federal Reserve Chair, Jerome Powell, has stated the Fed will support markets with an accommodating policy and keep rates on hold until 2023.

The S&P 500 Index is Primed To Expand Beyond Mega-Tech Growth Stocks

That brings us to the main point of this article: To make sure you know about concentration risk in the S&P 500 and market-cap-related benchmarked ETFs – and, importantly, to let you know how you can diversify with Seeking Alpha’s Value Screen. Seeking Alpha’s Top Value Stocks screen can instantly display and list Value recommendations from an algorithm that is refreshed every day. A key aspect of our Value recommendations is that the stocks also offer growth characteristics, as measured by their revenue, cash flow, and earnings growth.

S&P 500-related ETFs provide a passive approach to investing. And these ETFs are not without risk. If you instead choose to actively manage your asset allocation, you can find opportunities to add significant value in other parts of your portfolio. Among many reasons, the greatest benefits of actively managing your own portfolio can be measured in your ability to diversify your sector positions, mix investment style, focus on stocks that generate income, get defensive, or even update your portfolio with ESG stocks.

As S&P 500 valuation has now expanded beyond its 20-year average and is currently dominated by mega-tech growth stocks, now could be the perfect time to actively adjust your positions. For anyone who believes it is fortuitous to add value stocks, take a look below: choice picks from Seeking Alpha’s Top Value Stocks Screen, available to Premium subscribers.

Seeking Alpha Value Picks Have Great Grades Across All Investment Metrics

Mega-Tech Growth Stocks Exhibit Poor Grades On Value

The tables below show how the growth grades for a few value stocks stack up against the mega-tech growth stocks that are dominating the market right now. The growth grades and underlying growth metrics for these value stocks are impressive and very enticing when compared with the mega-tech growth stocks.

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D.R. Horton (NYSE:DHI) Has Better Growth Metrics Than Microsoft

It’s obvious that many of the mega-tech growth stocks in the above two tables are devoid of attractive value metrics. Conventional fundamental valuation metrics for these stocks are extraordinarily high vs. their sectors, as well as when compared with their historical five-year average. Alphabet’s forward P/E ratio is trading at a 96% premium to the sector and a 32% premium to its five-year average. Apple’s forward P/E ratio is trading at a 42% premium to the sector and a whopping 111% premium to its five-year average.

What is really surprising about the stocks and grades listed above is that the growth grades for many of the value stocks are actually more attractive than for the mega-tech growth stocks. Case in point: Allstate (NYSE:ALL) vs. Apple.

Allstate Has Better Growth Metrics Than Apple

Conclusion

In a fragile economic environment and a scorching hot stock market, actively managing your portfolio can help provide healthy diversification and reduce risk. Crucially, this article is not encouraging investors to liquidate their mega-tech growth stocks or S&P 500-related ETFs. In fact, with the Fed providing an unlimited backstop of easy money, there may well be a floor to the market or even further fuel for the mega-tech stocks. I’m simply pointing out the concentration risk in S&P 500-related investment vehicles and the over-stretched valuation of both the index and those five aforementioned stocks that are driving the index into the stratosphere. So the recommendation here is this: Strongly consider diversifying into value stocks to maximize sector and style diversification – and to minimize investment risk. Seeking Alpha provides a tool and screen to help investors instantly find some of the best value stocks in the market: SA’s Top Value Stocks screen can be found on the main menu bar in Top Stocks and under the drop-down section Ratings Screener.

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