More and more people are “protesting” against the disproportionate growth of the top 5 stocks in the S&P 500. Amid a sea of nonsense, there’s a valid concern buried within.
It’s not so difficult to understand how publicly traded financial assets work, and all we have to do is describe them in the way that they actually function to instantly become far more enlightened than the crowd that misses this fundamental nature and become lost within their illusions.
If you don’t get this one thing though, then you won’t ever know what’s going on with investments, and instead be lost in a mythical world that will only serve to misguide. Just as ancient people believed that thunder was the gods showing their anger, a lack of knowledge will tend to be displaced by myth, whether that be not understanding meteorology or how stocks are traded.
We now know why thunderstorms happen, but we haven’t made much progress in figuring out why the price of stocks move, where our understanding remains for the most part guided by mythology. When we look upon the world, upon all the insights out there to explain stock prices, the influence of this mythology is simply startling.
If someone dared to climb the mountain where the gods live to discover what may really be going on, what would surely be written on their tablet when they returned would be that stocks trade in markets where their price moves by way of the confluence of supply and demand for the asset.
The gods would tell us that all markets work this way, and there isn’t even any other possibility. They would be puzzled that we understand this with everything else, the price of bread for instance, and that we have people who work these things out on tables and graphs, but somehow, the market for stocks and other securities that are traded in markets are somehow different, and have been so willing to replace the obvious with myths.
While these market forces, changing levels of supply and demand, are subject to countless influences, we can never lose sight of the fact that it is these forces themselves, however influenced, that determine the trading price of these securities. That should be very obvious to us, but somehow it isn’t.
It also is not obvious at all to people how little attention we pay to market forces and how much weight we put on the myths that emerge out of our ignorance of this, by not only investors but those who they rely on to guide them, to preach to them the good word from the good book that contains our collective beliefs about these things.
We can look at virtually any belief that emerges from this investing religion and view it from the perspective of the truth, where market forces determine price, to see just how far out of touch their religion is, how big the gap there is between what should be completely uncontroversial truths and what they believe is the truth.
We should not ever dispute the fact that whenever the price of a stock goes up, demand exceeds supply, and vice versa when the price goes down. You don’t need an advanced degree in economics to be able to appreciate this, as the most cursory of understanding will do, and we do have this intuitively even though we choose to ignore it.
We can see a stock like Amazon, or Apple, or Microsoft, or Google, or Facebook, the big 5 of the S&P 500, go up in price, and somewhere within us, we get that this is happening because the demand side is winning, that people are willing to pay more and more for these stocks and this is causing their stock prices to rise, but these thoughts get pushed aside in favor of a lame attempt to outwit the market.
We then may come up with a variety of reasons why we believe that this cannot continue, and it doesn’t even matter what these reasons are if they do not in themselves speak to what really goes on with stock prices, changes in the supply and demand involved.
What we try to do instead is look away from what actually happens and fashion our own limiting beliefs upon the market, such as seeking to impose limitations based upon the business results of the underlying companies, and aren’t even discouraged when these beliefs fail to describe what actually happens in the real world of the market.
It is not that these things don’t matter, but these things at best only tell part of the story of what influences markets, where the market weighs all things, this plus many other factors, to come to their decision about which way to move and by how much.
Where we mess this up is that we mistakenly believe we are trading the companies themselves instead of trading the future beliefs about them, where these beliefs determine everything, beliefs we ignore and then limit ourselves to confusion and mistakes.
For instance, there is a view that there is some sort of cap on stock prices relative to their current earnings, where somehow, through some sort of unexplained alchemy, these earnings results in themselves determine price, without any other influence.
This can actually happen, but we should at least be open to trying to understand the thing and not just assume it and stick to the belief regardless of its merit. It is possible in theory that we see the price of a stock rise to 25 times its present earnings and then see this be a big enough issue that it will reduce demand for the stock independent of anything else, but we cannot just assume this happens by way of magic.
Only Supply and Demand Changes with Stocks Move Stocks
If and when such a thing occurs, it would clearly be due to demand for the stock being reduced enough by this belief, just like when we reach a resistance point on a chart and people see that and believe that the price will more likely stop there than not, and if enough people believe this, it will, because the concern reduces demand and increases supply, those who hold the stock and also see this.
We have less people wanting to buy the stock now because they see it at a point where they think it will probably back off. We have less people willing to pay more than this price, as well as more people willing to part with their stock to get out now before it rebounds, and if these forces align enough, we will indeed see a bounce off this price point where a prior move stopped and we create our own weather here, as we always do.
The same thing happens on the way up and on the way down, where people see demand increasing or decreasing and often choose to ride the waves up or heed the ones moving against them, and the increased demand or the increased supply that results can see these trends continue for a while until the momentum toward one side or the other peters out more, where market forces become more balanced.
Whether they balance out in a short while or continue on for a long time, or get stuck in periods where they remain balanced for a while, stuck in what we call sideways markets, will always depend on the changing confluence of supply and demand for the stock. Regardless of whatever else we are looking at, it must be viewed from the perspective of the market or it will be trying to ignore the proximate cause of price change and will seek to replace reality with something else.
As simple as this should all be, this is not how we tend to understand the movements in stock prices. Some of us do, but it is simply scary how few of us there are out there. All you have to do is look around the financial world to see how big a role dogma plays in their beliefs, as this world is really still back in the age where thunder means the gods are angry with us.
In this case, with the sound of the thunder that emerges when we misunderstand stocks this much tells us that the gods are actually angry with us, if the gods are understood to represent reality. We are very willing to take the punishment that these distorted beliefs result in, but don’t even hear the thunder this time around as we have plugged our ears as well as our minds, and just keep making these mistakes over and over.
There are all sorts of worries out there about stock prices being too high in a lot of people’s minds, where demand is increasing but it surely has to end because they think it should, and the fact that this demand isn’t dependent upon their beliefs but instead wholly determined by the beliefs of the market gets completely missed.
There are two main ways which these beliefs manifest, starting with the overall belief about the market as a whole, the stock market for instance, that has people putting in more or less money into stocks in general, aggregate supply and demand.
There is also the manner in which this aggregate supply and demand gets distributed on the micro level, where we can think of the macro level as the size of the pie and the micro level as how the pie becomes divided up as a stock or group of stock’s share of it goes up or down.
Stocks can continue to go up forever just by seeing the demand for stocks in general keep increasing, although we cannot just assume this will happen. It does during what we call bull markets but there are also times where supply takes control and we see prices overall decline, what we call bear markets.
Regardless of whether we are looking at the whole market, a group of stocks like a particular sector or index, or an individual stock, we need to view them by looking at how a particular change is expected to affect the market itself, the supply and demand that changes prices.
Nothing else in the entire world changes prices but this interaction between supply and demand. Nothing about the companies involved, nothing that happens to the economy, or anything else has the power in itself to do it.
When we got hit with COVID-19, stock prices didn’t get infected with the virus, the companies or the stocks involved didn’t either, but this did affect stock prices of course as it caused people to become afraid that this would cause supply to increase and demand to decrease for stocks notably. That’s exactly what happened, and the price changes were completely due to these changing market forces.
We cannot overemphasize the importance of understanding this principle. This is not a theory, it is not something that we can only be reasonably confident with, we know this with absolute certainty because this is the only possible mechanism that can ever change the price of stocks or anything else traded in a market.
When we wonder how much further these five big stocks of the S&P 500 can go, or how far the index can go, and we try to come up with ideas that involve anything but our looking to assess how supply and demand for stocks may be expected to proceed, we’re down to pinning the tail on the donkey and will most likely stab ourselves with the pin and feel the sting of our mistakes.
The Right Perspective Reveals Both the Imagined and the Real
Now that we’ve put on our magic glasses that see stocks the way the market does, we can now see how foolish some of the ideas that are out there about these things really are, things like stocks getting too pricey independent of market perception, or the idea that this would ever be possible without the element of the market thinking that they are and behaving accordingly. We may think that they are pricey but we look at prices going up and they aren’t seen as pricey at all now, we are proven wrong, but we have to understand we’re wrong.
We can speculate about the future, but if we want our speculations to be anything but pinning tails on ourselves, we need to watch the action unfold. We might have thought, for instance, that the market should stay down to reflect the economic crisis, but this assumes that demand will stay down, and when it didn’t, we simply have guessed wrong, and hopefully not missed or lost money on this guess.
The very idea that certain stocks might be overpriced requires that we first make sense of the idea that they are, but with our special glasses we can understand right away that the idea of it even being possible for a stock to ever be priced anything but at the exact amount is absurd. We get the prices by way of quotes and these quotes aren’t inaccurate and reflect what the market considers the stock worth right now, exactly.
Stocks weren’t overpriced back in 2000, they were worth what people were willing to pay for them at the time, although they did move up so quickly that when the tide turned as it always does, there were so many people who made so much money over such a short time that the normal movement to supply overtaking demand saw it completely overwhelm it for quite a while.
It doesn’t even make sense for us to even try to assign a value to a stock apart from where the market is valuing it, just like it wouldn’t with something like Bitcoin. The only difference between Bitcoin and Apple is that market valuation is more transparent with Bitcoin because there’s nothing else, nothing to confuse us. The same force moves the price of both stocks though in not just a similar fashion, but an identical one, where prices are bid to buy and offered to sell based upon current beliefs and the two sides come together and we get a trade.
Now that we have our market glasses on, the ones they give you in high school economics but somehow stocks have been wrongly given some sort of special exemption from, we’re ready to use them to look at this concern people have about what is seen as an excessive impact of these big five stocks on the S&P 500. Any ideas of valuation can now be seen as illusions, but we also need to realize that this is all about beliefs, so if the market believes that this is the ceiling and we can go no higher, this belief will weigh in on things and perhaps this will be the top for a while, just like traders sell at resistance and create it by way of their trading.
While the vast majority of the banter that goes on about stock markets are from people who have kaleidoscope glasses on instead, every now and then we do see an insight that is actually aligned with what actually goes on in the real world. There is one issue that does bear considering, and one that may indeed put the brakes on the S&P 500, an actually valid concern that may affect the supply and demand for this index enough to make a real difference.
Mutual funds buy a lot of stocks, as a lot of money is put into them by investors, and they operate by way of a set of rules. Many have a rule that they do not wish to ever have more than 5% of their fund in a single stock. This is something that can indeed affect the supply and demand of these stocks, because it can both cap the demand for this fund for them, as well as cause them to have to add to the supply side by having to trim their holdings when these stocks increase in price to stay under this bar.
Strategist David Kostin of Goldman Sachs has looked in depth at the percentage that mutual funds now hold in Apple, Google, Microsoft, Amazon, and Facebook, the gang of stocks that so many that are invested in the S&P 500 are worried about due to their allegedly being overvalued.
Kostin calculates that Microsoft is already at the 5% threshold that is widely used, with the other four stocks all being around 4% right now, and that’s a real potential concern. We assume that he is just focusing on actively managed funds only, and not including index funds who just buy the index instead of actually picking the stocks, as these five already comprise more than this 21% that we get when we add up these numbers and this would therefore overrepresent things if this was counted.
This is a valid concern though, and we tip our hat to Kostin for actually bringing up something that matters alongside all the malarkey that we usually see with these commentaries. Kostin’s citing that their total valuation exceeds what the top five stocks in the index added up to in 2000 sees him return to the world of nonsense, and an idea like this perhaps takes us far away from the world of sensibility, where we need to ask how such trivia could matter now.
However, this insight is worth celebrating, as this is something we do need to take seriously. This will reduce the normal demand for not only these stocks but likely the index itself, as these stocks are carrying this index, being up so much on the year while the other 495 stocks are down collectively.
This 5% position limit is a foolish idea, and even the S&P 500 doesn’t have such a thing, but to the extent that it is followed, and it will be because these fund managers actually believe that going over this is somehow a bad idea, we’ll feel it. It doesn’t matter how wise of foolish a trading decision is, its effects are the same.
This effect does get diluted by all the action from index funds and ETFs, so this is not a matter of seeing the progress of these stocks halted at the 5% mark, but it will slow it down, and perhaps notably when we consider the ripple effects of this.
This could even extend its reach beyond even the indexes that these stocks are a component of, and this reach already extends to all three big cap indexes, including the Dow and the Nasdaq.
These stocks are big enough to weigh in on the market itself significantly, reducing aggregate demand and increasing aggregate supply for stocks in general, where the progress of indexes being muted causes less people to be bullish, and that’s not even counting ripple effects. The macro level is a big influencer and when you see stocks move up or down together, that’s the macro effect in action, and we see a lot of this of course.
Kudos to Kostin for having the presence of mind to work this out and bring this up. He also warns that as these stocks have held up the rest so well, the downside is no small matter either. Their disproportionate weighting brings down the index as surely as they bring it up, and those exposed to the index need to be aware of the larger negative potential involved from this and take heed. That’s good advice.