There’s a simple way to invest to take advantage of a big trend reversal.
The S&P 500 (^GSPC 0.41%) soared to new highs in recent weeks as the bull market has barreled into its third year. But not every stock has participated equally in the rally.
Over the past few years, big tech stocks have had an outsize impact on the value of the S&P 500. Innovations and investments in artificial intelligence (AI) have been a major factor over the last two years, favoring the biggest companies with cash to spend. As a result, the big have gotten bigger.
And there’s good reason for that. Investors expect all the AI spending to pay off over the long run with faster earnings growth, and they have bid up the prices of these big spenders based on high expectations for the future. Meanwhile, those without the capital to invest as much in AI, or who simply aren’t as directly affected by AI innovations, haven’t seen their valuation climb to the same extent.
But one indicator suggests the recent trend of the biggest companies getting bigger at a pace that far exceeds the rest of the market could be coming to an end soon. And there’s a great way you can invest to take advantage of the next leg up in the stock market.
Image source: Getty Images.
A big flashing warning sign for investors
At big tech companies have outperformed, the market has become increasingly concentrated in just a few big winners. For example, the three biggest companies in the world, Apple, Nvidia, and Microsoft, have come to account for over 20% of the entire S&P 500.
S&P Global uses another metric to assess market concentration. It takes the average market capitalization of the S&P 500 and compares it to the index-weighted average. The latter will put more weight toward companies with bigger market caps. As market concentration increases, the ratio of the weighted average to the unweighted average will climb.
As of this writing, the ratio sat around 10 to 1. That’s higher than any level calculated by S&P Global dating all the way back to 1970.
That should be a big warning sign. Those investing in a typical S&P 500 index fund aren’t as diversified as they might think. Worse, if the concentration trend reverses (and these trends tend to reverse at some point), investors could be in for a prolonged period of below-average performance. Market concentration is one of the factors behind Goldman Sachs‘ recent forecast for a decade of minimal market returns.
When will the trend reverse?
It’s impossible to predict when the market will start rotating away from the big tech names that have propelled the S&P 500 higher over the last few years, but there are signs it could be sooner rather than later. It’s not just that the market has reached a new high-water mark of concentration, it’s that economic factors could favor smaller businesses.
As the Federal Reserve raised interest rates and the money supply tightened, it amplified big tech’s advantage of being able to spend heavily on growing their businesses and getting ahead on artificial intelligence. The reverse could be true in the future.
In September, the Fed made its first interest rate cut since 2020, and it could be the start of a long cutting cycle over the next few years. U.S. money supply is already growing at an accelerating pace, which is one of the first signs of a reversal in market concentration. As such, the shift could happen as soon as next year.
The simplest way to invest in a trend reversal
There’s no need to pick out the “best of the rest” in the S&P 500 if you want to avoid the stocks that have driven the market to such high levels of concentration. There’s no guarantee that Apple, Nvidia, and Microsoft won’t continue to dominate the market for some time. But investors can decrease their exposure to the biggest companies and increase the amount they invest in the smaller constituents of the index by buying an equal-weight S&P 500 index exchange-traded fund (ETF).
The Invesco S&P 500 Equal Weight ETF (RSP 0.06%) is the easiest and most cost-effective way to invest in the equal-weight index. Its expense ratio is 0.2% and is managed to avoid capital gains distributions since its inception. It simply invests an equal amount in every constituent of the S&P 500, rebalancing every quarter alongside the official index.
Over the long run, the equal-weight index has outperformed the market-weighted index. Naturally, it outperforms in years where market concentration decreases, and underperforms in years of increasing market concentration.
As such, the last five to 10 years haven’t favored the equal-weight index. But if you think the current level of concentration is unlikely to continue, you might consider adding the Invesco fund to your portfolio or shifting some of your assets to the equal-weight index.
Adam Levy has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Goldman Sachs Group. The Motley Fool has a disclosure policy.