I’m not an index fund fan. I never like being forced to buy the worst stocks in the market simply because they’ve had a good enough track record to grow to prominence.
That’s why I actually see some positive signs glinting in another week of market carnage. While the indices are suffering, investors who avoid the heaviest-weighted names are actually doing relatively well.
It truly is a stock picker’s market. There are clear winners and losers. If you buy them all indiscriminately and hold for the long haul, I have a strong feeling your nerve has been tested as your returns evaporate.
And because so many of the biggest stocks have been big losers lately, you aren’t going to succeed by sticking to the go-to names that have worked in the past. Amazon (AMZN), Microsoft (MSFT) and their peers generated trillions of dollars of wealth historically . . . but where do they go from here?
For index fund investors who are hugely overweight these companies, that’s a serious and ominous question. For the rest of us, I hope it comes as a relief. As long as you pick good stocks and avoid bad ones, you can actually make money in this market.
This is not just me speaking up for novelty, innovation and disruption in the face of a stagnating macroeconomic environment, either. I love novelty. But chasing novelty for its own sake isn’t investing. It’s just entertainment.
Instead, what I’m seeing is that the biggest companies in practically every sector are now a drag. The funds that hold them are so top heavy that it only takes one or two big names stalling to obscure good things happening under the surface.
Just look at the way the small-cap Russell 2000 has outperformed since the end of June. Those relatively obscure stocks are up 5.7% this quarter . . . despite anything you might assume about how vulnerable they are to an economic slowdown or how fragile their shareholders’ moods might be.
When these companies are rallying this hard, it’s hard to argue that investors actually believe that a savage recession is coming . . . at least on this end of the economy. After all, the Russell is a lot closer to local business, where things are so hot that the Fed is desperately trying to cool things off.
The S&P 500, on the other side of the scale, is barely up 2% over the same time period. Small stocks are outperforming. Big stocks are underperforming.
And in many cases, big stocks are tanking, taking their index funds with them. Microsoft (MSFT) down 27%. NVIDIA (NVDA) down a blistering 57%. The two of them together are so massive that they account for 25% of all capital flowing through the technology sector.
Their combined weight has been a 2 percentage point drag on sector index funds. But here’s the thing: the sector funds are actually flat in the current quarter, which means all other tech stocks put together have gained 2 percentage points to compensate for the damage these two giants have caused.
Apple (AAPL) is doing all right. It’s been a better stock. But the smaller stocks down the Silicon Valley food chain are doing just as well. They’re making progress. They’re winning.
You just can’t see them if you’ve been forced to own a lot of MSFT and NVDA simply because those are big companies. I’d rather own AAPL and a mix of smaller names. This is what we do in my GameChangers portfolio.
What about AMZN, you ask? The consumer sector is actually having a great quarter, which again flies in the face of claims that the economy has already blown out.
AMZN is doing okay, holding up with the rest of the sector. I worry about its long-term prospects as it tries to regain profitability. I think management has given up on growth. They’re looking for efficiency and market share at this point . . . grinding rivals from FedEx (FDX) to Shopify (SHOP) into the dirt in the process.
That’s not really a sustainable business model for a dynamic company. It’s a business model that signals maturity. It means you’ve come as far as you can.
Tesla (TSLA), meanwhile, is growing fast and the stock reflects that growth. But here’s the deal. AMZN plus TSLA are almost half of the consumer sector by market capitalization.
The “bottom half” of the sector is up a sizzling 28% so far this quarter. That’s roughly in line with TSLA . . . and double what the sector as a whole has delivered over the same period.
AMZN is holding the index funds back. Why own a laggard while it’s behind the growth curve?
And by the way, if smaller and more vulnerable consumer stocks are up 28% in three months, that’s not exactly a crash signal. It’s a signal that money is rotating away from AMZN and other giants into names that actually have room to expand.
That’s how a healthy market works. We could do this sector by sector, but I think you get the idea. Investors are not dumping all stocks en masse. They’re simply lightening up on weaker giants and rolling back into their favorite small names.
Look at biotech. IBB is size weighted and up 4% QTD, which shows that “speculation” isn’t dead. But XBI is equal weighted so little stocks contribute as much as big ones. It’s up 9%. Little stocks are winning harder.
You can’t even find little stocks in the sector funds until trillion-dollar titans give up a little room. And even if a giant like NVDA gets cut in half, that liberates hundreds of billions of dollars that could translate into massive gains for companies that collectively have a much smaller profile.
It takes work to find these companies. But that work can be rewarded right away when you pick the right name and have the conviction to hold on. Look at the charts for yourself. Do the math.