January '24 Investment Memo
The 'Magnificent 7' and What Actions Should I Take On My Portfolio to Start the Year?
A Blistering Final Quarter of 2023
Markets have been choppy at the start of the year, although they are now showing a slight gain over the course of January. The choppiness isn’t unexpected after a blistering rally in the 4th quarter of 2023.
U.S. Small Cap stocks led the way with a 14% return over the final three months of 2023. Large-cap global stocks were not far behind with an 11% return, and emerging markets trailed with a not-so-paltry 8% return.
All to say, it was a good quarter.
Choppy Rebalancing Cycle
Large institutions often go through their rebalancing cycles in January, balancing the portfolios they manage to their target asset and sector weights. It makes for an active start to the year. In fact, in stock trader lore, there is something called The January Barometer. As January’s performance goes, so goes the rest of the year.
I don't put weight on such things, but it is an interesting reflection of underlying market dynamics.
We often think of the market as a thing, its own entity. But it's really a reflection of all of us. It moves based on billions of transactions every day from hundreds of millions of investors. And those investors are basing their decisions on billions of global citizens' actions, needs, and wants.
It’s easy to conceive of the market as an outside force that impacts you. But what is often missed is that all of us also impact the market. First, with our investing, no matter how small or large our portfolio is. But also, by choosing between Dunkin Donuts and Starbucks for our coffee and countless other tiny decisions,
Your decisions and the choices of hundreds of millions, if not billions of others, flow through to company earnings, which influence stock prices.
The Magnificent 7
Recently, an interesting thing has manifested. A group of companies have become ridiculously successful, and, as a result, their stocks have outperformed for many years. They are called the Magnificent 7.
No, not those ones. These ones:
After a period of outperformance -massive outperformance in the case of Nvidia and Tesla - The Magnificent 7 now makes up nearly 30% of the S&P 500.
It gets even more telling. Let’s say you want global diversification, so you invest in a fund that tracks a global index, like the MSCI All Country World Index. The Magnificent 7 still accounts for over 15% of the index, a larger allocation than the stocks of the U.K., China, France, and Japan combined!
Too Much Investment Concentration?
That's a lot of concentration! Is that much concentration a good thing or a bad thing?
First things first, it’s just a thing. And despite media reports, it’s probably not something most investors should worry about or think about all that much.
But we do have some historical perspective on how this might play out.
Dimensional did a study going back to 1921 on the performance of the ten largest US stocks before and after achieving that title. What they found is that the largest companies outperformed on the path to becoming one of the largest capitalization stocks traded but underperformed in the ensuing years.
Here is the chart:
The annualized returns show numbers in excess of overall US market returns. So, that’s quite some out performance in the years prior. However, after, returns are at best similar to the overall U.S. market, and potentially trail over the next 10 years. Why? Because it’s hard to maintain competitive advantages in capitalism. Other companies develop their own technology or value propositions and come after your market. Consumer interests shift. Capitalism encourages this, and it’s good for innovation and consumer choice.
So what’s the solution?
Well, nothing too dramatic. And, nothing novel. For example, don’t sell all your large-cap stocks because of what some guy on the internet said (Me! I’m that guy!)
The answer is to diversify.
I suggest you reflect mindfully on your overall portfolio concentration. Are you over-allocated to US large-cap growth stocks, like the Magnificent 7? A tip-off would be if your biggest positions are, for example, hot technology or growth funds. These types of funds tend to congregate their positions in many of the same stocks, like the Magnificent 7.
If so, consider allocating toward small-cap, value, and international stocks. This will improve your portfolio diversification both among asset classes and globally.