When it comes to the major indices, most investors are familiar with the importance of just a handful of stocks…

Stocks like Meta (formerly Facebook), Apple, Amazon, Netflix, Alphabet (Google), Microsoft, and even Tesla all have a massive influence on how those indices perform.

Not only do millions of investors buy shares in each of these directly, but we can find each of these stocks in a variety of exchange-traded funds (ETF).

Many of those stocks are heavily weighted in those ETFs… For example, the 10 biggest stocks in the SPDR S&P 500 ETF Trust (SPY) make up over 25% of its market value. The top 10 in the Invesco QQQ Trust (QQQ) make up 48%.

And Apple appears in around 403 different ETFs in the U.S. alone. That makes many of those ETFs vulnerable to a correction in Apple.

But there’s a bigger picture we should keep in mind…

Add in the hundreds (or thousands globally) of ETFs holding these high-profile stocks, and you have a massive concentration of risk that many investors simply aren’t aware of or choose to ignore.

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. That meant the nearly $10 trillion global ETF market at that time had doubled in just three years.

And I warned my readers about the risk this posed…

I knew if the market changed the way it values these high-profile companies – for example, due to a rise in interest rates or lower growth – then it would become increasingly difficult for them to keep their lofty valuations…

And that’s exactly what we’ve seen during 2022.

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

At the start of this year, Microsoft had a P/E of around 40 (when I started trading it, the P/E ratio was around 7 or 8). Netflix’s was around 48. And Tesla’s P/E was in the hundreds. They were all clearly priced for extraordinarily high growth.

But when the market applies a P/E ratio at so many multiples above historic levels, that makes them exposed – and vulnerable to slowing earnings as well as investors’ changing beliefs about their potential growth.

When those factors do a U-turn, then ultra-high P/Es can quickly fall… And those stocks – as well as the hundreds of ETFs they’re in – become due for a correction.

We’ve seen that play out this year… Microsoft now has a P/E of 24. Netflix’s P/E dropped to 22. And Tesla’s P/E has sunk to 55.

And the falls of these giants are a significant part of why an ETF like QQQ has tumbled over 31% year to date. Likewise, the SPY has dropped nearly 19%.

Rethink the Risk of “Buying the Market”

The trap for investors is that they believe that these high-profile mega-cap stocks are as safe as holding a utility because of their sheer size and scale.

However, they’re not being priced like utilities. Their P/E ratios trade several multiples higher. So these stocks (and the broader market) feel the full brunt when investors change their minds on earnings growth and interest rates start to tick higher.

Investors who blindly 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 (or lack of) of their investment depends on just a handful of stocks.

And as we’ve seen, we should pay attention when the P/E ratios tell us that the values of those stocks are overextended.

Regards,

Larry Benedict
Editor, Trading With Larry Benedict

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