When it comes to the major indices, most investors are familiar with the importance of a handful of stocks, such as the Magnificent Seven…

Nvidia, Microsoft, Apple, Amazon, Meta Platforms, Alphabet, and Tesla all have a massive influence on how major indices perform.

Millions of investors buy shares directly, and many of those stocks are heavily weighted in various ETFs…

For example, the 10 biggest stocks in the SPDR S&P 500 ETF Trust (SPY) make up around 37% of its market value. Just a few years ago, that stood at 25%.

And the top 10 stocks in the Invesco QQQ Trust (QQQ) – which tracks the Nasdaq – make up 51% (up from 48% a few years ago).

Their frequent appearance in ETFs is noteworthy as well. Apple appears in over 500 different ETFs in the U.S. alone. Many of those ETFs are vulnerable to a correction in Apple.

And Apple is just one example of the bigger picture…

Hundreds of ETFs hold these high-profile stocks, creating a massive concentration of risk.

And that has major ramifications for the market when you consider the amount of money involved…

Vulnerable to a Fall

2021 marked the first year that funds flowing into ETFs globally exceeded $1 trillion. The nearly $10 trillion global ETF market (at that time) had doubled in just three years.

Now, as of June this year, that global ETF market is nearing $17 trillion.

And that’s why I have continued to warn my readers about the risk this poses…

If the valuation of these high-profile companies comes into question – for example, due to interest rate changes or slower growth – then it will become increasingly difficult for the market to keep soaring…

Let’s take a closer look…

High Valuations

One of the most common metrics used to value stocks is the price-to-earnings (P/E) ratio.

That’s the stock price divided by its earnings per share. It tells you how many years of earnings it would take to match the current share price.

The P/E ratio gauges a company’s earnings potential. The higher the P/E ratio, the higher investors believe the earnings growth will be.

Yet many of these high-profile stocks have nosebleed P/E ratios right now. Microsoft recently traded around 8% off its July 31 all-time high. But its P/E is still tracking around 37. (When I started trading it, that P/E ratio was around 7 or 8.)

And high P/Es can change rapidly. When tech stocks sold off around 2022, Microsoft’s P/E fell from around 40 to 24. During that same period, Netflix’s P/E was more than halved from around 48 to 22. (It’s now back up around 52.)

Then consider recent market darlings Palantir and Broadcom. Their rapid growth has handed them bigger weightings in a broad range of ETFs – with P/Es of around 550 and 90, respectively.

They’re clearly priced for extraordinarily high growth…

But extremely high P/E ratios leave stocks exposed to any bad news – such as sub-par (or simply slowing) earnings.

The stocks are vulnerable to investors’ changing beliefs about their potential growth… and become due for a correction…

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Rethink the Risk of “Buying the Market”

Many people believe that high-profile mega-cap stocks are as safe as utilities because of their sheer size and scale. That’s a trap.

Mega-cap stocks aren’t being priced like utilities. Their P/E ratios trade at multiples higher.

So these stocks can feel the full brunt when those valuations come into question.

Vitally, investors who hold broad-based ETFs and think they’re safe because they’re “buying the market” need to really rethink their risk.

In reality, the success of their investment depends on just a handful of stocks.

And we should pay attention when the P/E ratios tell us that the values of those stocks are overextended…

Happy Trading,

Larry Benedict
Editor, Trading With Larry Benedict

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