Are broad stock indexes really broad?

Stocks had a mixed close on Friday as tech earnings held back the indexes after some bad earnings announcements.  Flash Purchasing Managers Indices showed promise for the hard-hit services sector, beating economists’ expectations.

N O T E W O R T H Y

Read the label before consuming.  I don’t know, it seems quite logical that one would want to know what is actually in the foods that one eats. When I was young, it was rare to see shoppers staring at the sides of packages at the market, while today, it seems that the only folks not looking at labels are the professional shoppers who seem intent on running the rest of us over with their carts.  The US was the first to require food labeling of any kind in 1913 and in 1938, the Food Drug and Cosmetic Act made it mandatory for producers to reveal artificial colors, artificial flavors, or chemical preservatives. In 1990 the Nutrition Labeling and Education Act made the nutritional labels that we all know and love today a requirement.  So, most of now at least glance at labels and ingredients of the things that we eat.  When it comes to investing, many of us hold ETFs and Mutual funds alongside our stock investments.  While that is a sound strategy, many folks may be overweighted in certain sectors, industries, and stocks themselves.

Over the past 20 years, index investing has gained in popularity. Legendary stock investor Warren Buffett himself has sang praise to index investing as has CNBC wild man investing aficionado Jim Kramer.  Investing in a broad index gives holders exposure to more stocks than the average investor could ever possibly manage. Buying an Index ETF (exchange traded fund) is cost effective and does a good job at mirroring the performance of their underlying index.  If you invested and held the QQQ (Invesco Nasdaq 100 Index ETF) or the SPY (SPDR S&P 500 ETF) for the past 20 years you would have received total returns of +1116% and +495% respectively.  Not too shabby, and you would have only had to hold on to 2 securities.  So, it is no wonder that many retail investors began to add these and similar ETF’s to their portfolios, especially in the aftermath of The Great Recession market rout.  All good so far.  In talking with clients I see many self-styled portfolios.  You may not be surprised, based on the returns I just cited,  that many of the portfolios contain one or both SPY and QQQ.  I recently looked at a portfolio that contained those two ETFs along with Apple.  That is it, just three securities.  The client had done very well and was pleased with returns, especially for the first half of last.   They were concerned that, not only had their portfolio lost some of its zip, but also it had become very volatile, moving up and down in large swings. Granted, they still earned quite significant returns in the high 40% range over the past 18 months, but the volatility had become a bit disconcerting to them.  They asked me why their portfolio had become so volatile. Between the two ETFs and Apple, they owned almost 801 positions (500 SPY, 100 QQQ, and Apple, though that is not technically the case, but it is close).  Shouldn’t that provide considerable diversity?  I asked if they liked Apple, and they chuckled saying “of course, 5% of my portfolio is invested in it.”  I reminded them that both ETFs also contained Apple, and they acknowledged that saying, “yes, it is in both the S&P500 and the Nasdaq 100.”  I asked if they knew that Apple made up 6% of the S&P500 and 11% of the Nasdaq 100.  So, with an allocation of 57% in QQQ and 38% in SPY, their Apple exposure was really 13.6%, far greater than the 5% they thought.  A big part of their portfolio’s daily performance was reliant on Apple. Making matters a bit more complicated is that the FANGS+ (Facebook, Apple, Amazon, Netflix, Google, and Microsoft), which frequently trade in a correlated way, dominate the top ten allocations in both the SPY and QQQ.  In fact the FANGS+ make up 22.4% of the SPY and 42.4% of the QQQ.  See where this is going?  To own both of those ETFs, investors must have an unwavering faith in those 5 stocks.  Such conviction can earn great returns when those stocks perform well… and lots of indigestion when they don’t. There is another part of this story which played out on Friday. Snapchat (SNAP), the social media company, announced earnings after the bell last Thursday.  While the company beat EPS estimates and slightly missed Revenue expectations, weaker forward guidance sent the stock tumbling by -26.6% in Friday’s session.  SNAP is not in the S&P500 or the Nasdaq 100 but both indexes fell on Friday due to their top-weighted stocks pulling back in sympathy with Snapchat.  So when I spoke to that client, I should have asked if they liked Snapchat’s stock, to which they would most likely have responded with a puzzled look. Knowing the contents of your food AND your investment portfolio is smart.  What is Butylated Hydroxytoluene, anyway?

THE MARKETS

Stocks had a mixed close on Friday as the indexes were held back by some weak tech earnings released after Thursday’s close. The S&P500 fell by -0.11%, the Dow Jones Industrial Average gained by +0.21%, the Nasdaq Composite Index dropped by -0.82%, the Russell 2000 gave up -0.21%, and the S&P500 ESG Index slipped by-0.06%.  Bonds gained and 10-year Treasury yields fell by -7 basis points to 1.63%.  Cryptos gave up -2.26% and Bitcoin sold off by -3.12%.

NXT UP

– Chicago Fed National Activity Index (Sept) is expected to have slipped to 0.20 from 0.29.

– Dallas Fed Manufacturing Activity (Oct) may have climbed to 6.2 from 4.6.

– This morning OTIS Worldwide beat on EPS and Sales while Kimberly-Clark missed on EPS but beat on the top line.  After today’s close we will hear from Facebook.

– The week includes some 150 S&P500 member announcements along with lots of housing numbers, regional Fed Indexes, Consumer Confidence, Durable Goods Orders, GDP, PCE Deflators, and University of Michigan Sentiment. 

Please refer to the attached earnings and economic calendars for details.