Over the last several years passive investing, via index funds, has been in favor like never before. On the way up, this style makes complete sense; however, on the way down, this precise investment theme creates systemic dangers which we’re seeing play out in the market right now.
First off, it is the way in which the S&P is constructed in that it is market cap weighted and therefore can easily become lopsided. I’ve written about this in the past HERE. In summary, what has happened as a result of this passive popularity is a very skewed index with much more emphasis on just a few stocks. In fact, as I write, the technology sector now represents 24% of the S&P 500, up from just over 20% at the end of 2016. While imagining that out of every dollar that enters the S&P almost 25% goes into technology isn’t scary enough, the disproportionate weighting continues with the top 4 stocks in the index commanding over 42% of the entire basket. In summary, this means that Apple, Google, Microsoft and Facebook represent over 10% of the entire S&P 500. Let that sink in for a moment. Out of 500 companies, only 4, or less than 1% of all 500 companies, impact the S&P daily performance by more than 10%. Is it any surprise that when these core stocks finally correct in the form of 4% and 5% in one day, that a similar 4% market decline takes place?
In addition, it is important to understand that with the billions upon billions of dollars that have rushed into index funds over these last few years, when these market participants decide to exit in order to meet these redemptions, institutions sponsoring these vehicles such as Vanguard, Fidelity, etc. must be selling stocks indiscriminately across all sectors. In the past, with a bulk of money in actively traded mutual funds, managers would hide out in certain sectors and this is precisely why, in past declines, you may have found green in defensive sectors such as staples or utilities. In today’s market however, selling takes place across all sectors because that is how liquidation must occur in a passive index environment.
While we too gave back some recent gains, I feel very comfortable with our current allocation cash position and most importantly our plan with each and every investment we own. I can’t even imagine navigating this or any other environment without a sound investment plan and the experience needed to navigate turbulent waters.
For those outside of our actively managed accounts, making regular deposits to retirement funds and still within the contributory phase of your life, the irony is that a market correction should be a welcome sign as you Dollar-Cost average into stocks at lower prices and continue following your plan of attack with an appropriate risk tolerance and allocation strategy.
For those within our managed account strategy, please know that we are watching the action closely and at this point have yet to be stopped out of any remaining positions; however, we won’t hesitate to raise cash and take an even more defensive posture should the selling continue and the predetermined levels from which we must exit do, in fact, transpire.
We all knew that a significant correction would come sooner or later. Now that it is upon us we must approach the volatility with patience and a clear plan. Thankfully, we have both.
Until next time