Why the Stock Market Might Be at Peak Concentration Risk

Summary

Odd Lots Podcast Summary
Episode Title: Why the Stock Market Might Be at Peak Concentration Risk
Release Date: January 24, 2025
Hosts: Joe Weisenthal and Tracy Alloway

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Introduction

In this episode of Odd Lots, hosts Joe Weisenthal and Tracy Alloway delve into the burgeoning concern of concentration risk within the stock market, particularly focusing on the S&P 500. They explore the increasing dominance of a select few large-cap stocks and the implications this trend holds for investors and the broader market.

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Understanding Concentration Risk

Tracy Alloway opens the discussion by highlighting the alarming statistics regarding market concentration:

"I think Goldman Sachs said that the top 10 stocks now account for something like 38% of the S&P 500, which is a record and seems quite a lot on the face of it. And I saw another number out there saying 26 stocks now account for half of the entire value of the S&P 500."
-- [03:07]

Joe Weisenthal echoes the frustration surrounding this trend, emphasizing how traditional investment strategies are being upended:

"And then all these old strategies of like, oh, we're going to buy cheap or buy cheap low book value, you know, price to book and all these traditional investing patterns, it never mean reverts for years and years and years, except for like five minutes in 2022. They just go straight up."
-- [02:18]

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Guest Introduction: Kevin Muir

The conversation is enriched by the presence of Kevin Muir, a renowned macro economist and the voice behind The Macro Tourist blog. Tracy Alloway introduces Kevin, highlighting his extensive background in equity derivatives and his pivotal role during the technological boom of the 1990s.

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Kevin Muir’s Insights on Concentration Risk

Kevin Muir provides a historical perspective on market concentration, drawing parallels with past economic events:

"This is something that is experienced in Canada. As I mentioned, I'm a Canadian and I was on the index desk at a time when Nortel was actually 35% of the entire index."
-- [07:39]

He elaborates on the inherent risks of such concentration, referencing Goldman Sachs' analysis which equates the current levels to those preceding significant market downturns like the Great Depression and the dot-com bubble:

"If you look at it, we are now just as concentrated as we were right in front of the Great Depression in 1929, in the Nifty 50 in the early '70s, and the dot-com bubble in the late '90s. Well, all those times were not good times to buy stocks for forward returns."
-- [10:19]

Muir emphasizes that despite arguments assuring investors that the concentration in the U.S. is better than elsewhere, the risks remain substantial:

"It's, it's, it's a worrisome kind of new development in the US And I don't buy the argument that just because other countries are more, you know, concentrated that we shouldn't worry about it in the US and all you have to do is look."
-- [10:19]

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Impact on Index Providers and Financial Professionals

The discussion shifts to the role of index providers in managing concentration risk. Kevin Muir explains how changes in index rules, such as the 25/5/50 rule, are responses to growing concentration concerns:

"The Russell 1000 Growth Index ... are bumping up against that [25/5/50] ... they chose instead of using the five and the 50 rule, they used four and a half and 45."
-- [20:15]

He highlights the proactive measures taken by index providers like Russell, who have adjusted their methodologies to comply with regulatory constraints and manage the oversized influence of major tech stocks:

"They are actually getting ahead of their problems of potentially going and bumping up against this 25,5 50 rule."
-- [20:15]

Tracy Alloway raises concerns about the reflexivity of index construction and its broader implications:

"When they're making a decision to change the weighting on something like tech, does that perhaps open them up to more scrutiny, perhaps from regulators?"
-- [31:19]

Kevin Muir responds by clarifying that the changes are driven by regulatory requirements rather than a judgment on sector risk:

"They're saying we need to comply with this 25, 5, 50 rule, which is an IRS rule. It has nothing to do with a decision that they think that the Mag 7's gotten too risky."
-- [31:19]

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Potential Market Implications

The hosts and Kevin Muir discuss the potential repercussions of peak concentration risk. They speculate that the market might be approaching a tipping point where the heavy reliance on a handful of stocks could lead to instability:

"I could make the argument that we're kind of at the peak of concentration here and that this is the market correcting what has become too concentrated of a market."
-- [33:13]

Joe Weisenthal brings up the concept of reflexivity, where market behaviors reinforce concentration trends:

"Reflexivity that I mentioned at play in the market where, you know, the big attract more inflows, they get more capital, they get bigger, maybe they get more pricing power and then that leads to more earnings. So you have this sort of cycle going on."
-- [37:00]

Kevin Muir adds that the market has become less efficient, with quantitative models and momentum trading exacerbating the concentration issue:

"Part of the reason the market has become less efficient is because of quants themselves. They become a larger and larger portion of the trading in the market... There's very little of the kind of David, the old David Einhorn."
-- [34:23]

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Conclusion

The episode concludes with the hosts reflecting on the profound implications of concentration risk. Kevin Muir underscores the urgency for investors and financial professionals to recognize and address this trend to mitigate potential risks:

"When I look at this situation and think about how this is going to play out going forward, I could make the argument that we're kind of at the peak of concentration here and that this is the market correcting what has become too concentrated of a market."
-- [33:13]

Tracy Alloway and Joe Weisenthal agree on the necessity for ongoing vigilance and adaptation in investment strategies to navigate the evolving market landscape.

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Key Takeaways

• Market Concentration: A small number of large-cap stocks now dominate a significant portion of the S&P 500, raising concerns about systemic risk.

• Historical Parallels: Current concentration levels are comparable to those before major market disruptions like the Great Depression and dot-com bubble.

• Index Providers’ Role: Adjustments in index construction rules, such as moving to the Russell 1000 Growth Index with modified capping rules, aim to manage and mitigate concentration risk.

• Investment Strategies: Traditional diversification strategies may be insufficient in the face of increasing concentration, necessitating new approaches and heightened awareness among investors.

• Future Implications: The market may be at a critical juncture where excessive concentration could lead to heightened volatility and potential corrections.

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Notable Quotes

• "We are now just as concentrated as we were right in front of the Great Depression in 1929..."
  — Kevin Muir [10:19]

• "We're all kind of been lulled into this feeling that everything's okay. It's... it's a broad index and it's no longer as broad."
  — Kevin Muir [27:17]

• "If you want something, they're going to do it."
  — Kevin Muir [31:19]

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For more insights and detailed discussions on finance, markets, and economics, subscribe to the Odd Lots podcast by Bloomberg.

Transcript

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[Tracy Alloway]

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[Tracy Alloway]

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[Joe Weisenthal]

We have a very special announcement. Joe and I are hosting our annual Fraught Lots Pub quiz on Thursday, February 13th in New York City and it's going to feature some very special guests and prize. So come test your wits in finance markets and economics for a chance to win the ultimate Odd Lots glory and hang out with your fellow listeners. Tickets are on Sale now at events.bloomberglive.com oddlotspubtrivia. You can also find links on our Twitter feeds or in the newsletter. And you can find the link also on our show Notes. We hope to see you there.

[Kevin Muir]

Bloomberg Audio Studios Podcasts Radio News.

[Tracy Alloway]

Hello and welcome to another episode of the Odd Lots podcast. I'm Tracy Alloway.

[Joe Weisenthal]

And I'm Joe Weisenthal.

[Tracy Alloway]

Joe, do you remember when you first heard the term mag7?

[Joe Weisenthal]

You know, I don't if I'm being honest, but you know these acronyms that for big tech stocks, like they kind of, you know, people used to talk about Fang.

[Tracy Alloway]

Right, I know. I was just thinking that like when did the handoff from FAANG to MAG7 actually happen?

[Joe Weisenthal]

We need to do one of those like Google Trends NGRAM things. That's a good question because. Yeah, and then there was like FANG plus and then famg, but they're all kind of the same thing. It's just big tech stocks.

[Tracy Alloway]

Right. So the, the terminology, the acronyms might change, but I think the subject is always kind of the same and the concern is always the same. It's this idea that there is like a handful of big companies, usually tech stocks, that are driving the entire market.

[Joe Weisenthal]

Yeah. And it drives people crazy. Right. They're so big and they've grown so much and the stocks have done so well over the years and all these old strategies of like, oh, we're going to like buy cheap or buy cheat low book value, you know, price to book and all these traditional investing patterns, it never mean reverts for years and years and years, except for like five minutes in 2022. They just go straight up. And the only test of whether you're a good investor or not is whether you're overweight, whether you bought. Yeah, that's it. That's it.

[Tracy Alloway]

That. That really is the. The alpha nowadays. But, you know, you see these numbers thrown around. Like, I think Goldman Sachs said that the top 10 stocks now account for something like 38% of the S&P 500, which is a record and seems quite a lot on the face of it. And I saw another number out there saying 26 stocks now account for half of the entire value of the s and P500. So I think it brings up a bunch of interesting questions. How bad is the concentration? Is it intrinsically bad in and of itself? Is it actually that risky?

[Joe Weisenthal]

Yeah.

[Tracy Alloway]

And also, how are financial professionals and the market itself actually reacting to this concentration risk? So I think we should talk about it.

[Joe Weisenthal]

Totally. You know, I look at myself in the mirror and I say to myself.

[Tracy Alloway]

Do you point at yourself like that? Meme?

[Joe Weisenthal]

I. On some days I point and say, you're a good. Because, you know, I'm just like a boring index fund investor for my retirement, you know, So I point, say, oh, you're a good investor because you've been really long tech. And then I. And then on other days, they wake up and say, oh, you are really heavily exposed to 26 stocks. And so, you know, it's like glass half full. It's like, good, but also makes me a little anxious.

[Tracy Alloway]

You shouldn't take credit. You should give that credit to S and P. Thank you. And then when the market collapses, you should blame them.

[Joe Weisenthal]

I do. I say thank you to the wonderful fund managers at S and P. I only wish you hadn't. You know, every once in a while they have a dud. It's like, why'd you pick that one anyway?

[Tracy Alloway]

Or why didn't you include Tesla earlier?

[Joe Weisenthal]

Yeah, right, exactly.

[Tracy Alloway]

All right, well, without further ado, we do in fact have the perfect guest for this topic. Someone that I've wanted to speak to for a long time, and I can't believe we haven't had him on the podcast before. Major oversight on our part. We're going to be speaking with Kevin Muir. He is, of course, the macro tourist and a longtime voice on Fintwit and writing on his blog as well. So, Kevin, thank you so much for coming on. All thoughts.

[Kevin Muir]

Well, it's great to be Here. Thanks, Joe.

[Tracy Alloway]

And Tracy, maybe just to begin with, it's the first time you're on the show. I've always sort of known you as this voice that's hanging around in the finance blogosphere. But what, what's your background?

[Kevin Muir]

So I was the equity derivative, institutional equity derivative trader at RBC Dominion Securities. In the 90s. I was kind of at the forefront of the technological boom and the automated trading and the index trading and the taking off of all these index products. And then in 2000, I actually went off on my own and I thought, maybe, you know, I'll go work for a hedge fund. And I thought, well, the same time I can go and trade for myself for a little bit and see how that goes. And that's kind of 25 years later and I'm still doing it.

[Joe Weisenthal]

You write the macro tourist.

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What's your goal? What do you.

[Joe Weisenthal]

For those. We're both big fans of your writing, but what do you, what, what do you like to write about? What's your, what's your sort of goal with your writing?

[Kevin Muir]

Well, Joe, it originally started off as a diary, and I just kind of. Good traders, you're supposed to keep a diary. And I, and I would start writing things and then people would pull me up and ask me what I thought of the market, and I would send it off, and to them I would just go, well, here's what I wrote, my diary. Eventually they started ask often enough that we just started to put it up on the net. And then it took off from there. And from there I ended up going and actually started my podcast and meeting all sorts of people. And one of the kind of just great parts about being on the podcast is the fabulous people I got to meet along the way. I meet people like Jim Lightner and I've had Mike Masters on the podcast. And those people are market wizards. They're terrific. And I get to share ideas with them. And it's just I consider myself one of the luckiest guys in the world.

[Tracy Alloway]

So let's get to the topic at hand then give us some context around concentration risk in something like the S&P 500 right now, I threw out some numbers earlier, but how, how extensive is this concentration and should we be worried about it?

[Kevin Muir]

Well, Tracy, one of the things that people will kind of push back on when you say that the US has become more concentrated is they'll say things like, oh, but if you go look at other indexes around the world, they're also very concentrated. And that's absolutely correct. There's no doubt about it. This is something that is experienced in Canada. As I mentioned, I'm a Canadian and I was on the index desk at a time when nortel was actually 35% of the entire index.

[Tracy Alloway]

Wow.

[Kevin Muir]

So if you think that you guys are, we're having trouble dealing with this now. Just imagine having 35% of the index being one stock. It was actually even worse than that because we had kind of a Palm at Triple M situation where Bell Canada was one of our next biggest stocks and it main holding was all of its Nortel holdings. So it ended up being that the index managers were stuck. Because if you think about it from a fiduciary point of view, it doesn't make Sense to have 50% of your portfolio exposed to one stock. It's risky. And so one of the things that I'm hearing now when you bring up the problems about concentration risk in the US is they'll say, oh no, but don't worry, it's actually much better than the rest of the world. And I won't deny that for a second, but isn't that like saying my Mercedes is now using plastic knobs? But don't worry, the Honda uses plastic knobs too. Part of the reason that investors have been attracted to the US is that it is a diversified basket of many stocks. And just think about Warren Buffett. Warren Buffett tells you you can buy the S&P 500, you can sleep at night, but if you go and talk to investment advisors around the world and you ask them, do you think your clients really truly know what's underlying that basket? I think most of them would say they would assume that it's, it's roughly equal weight. And they would be shocked to learn that, you know, Microsoft, Nvidia, Apple are each almost 7% of their basket for a total of 21%. And so it ends up being, it's, it's a worrisome kind of new development in the US And I don't buy the argument that just because other countries are more, you know, concentrated that we shouldn't worry about it in the US and all you have to do is look. You trace, you mentioned that Goldman Sachs stat and they have another one that they published and they went back and they looked at concentration risk throughout the last century. And if you look at it, we are now just as concentrated as we were right in front of the Great Depression in 1929, in the Nifty 50 in the early 70s and the dot com bubble in the late 90s. Well, all those times were not good times to buy stocks for forward returns. So increasingly I think that we need to be aware that this is a risk and there's more and more conversation happening around that.

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[Joe Weisenthal]

I'm happy that Nvidia has been 7% or somewhere south of that in my portfolio. I didn't even have to do anything and I made a big allocation to one of the best performing stocks in the world. And not only that, I take your point about concentration, et cetera, and obviously very alarming. These also account for a huge share of the actual earnings too. There was a lot of concentration in 992000 with tech, but a lot of those companies weren't really making that much money. These companies are earnings juggernauts.

[Kevin Muir]

Well, no doubt you're absolutely correct Joe. And that's kind of the pushback to this argument that we're concentrated world. They'll say, oh, it's mag seven. It's a wide variety of different companies that do different things. It's not like it's all one industry. And not only that, the valuations aren't as crazy as they might seem. No doubt about it you can make that argument, but let's just imagine tomorrow that the AI bubble doesn't live up to its hype. Let's imagine that all of a sudden we have some sort of earnings surprise and these stocks get halved. It's not that hard to imagine. We went through it in 2022. So if that occurs, I think that people will be quite shocked at how their supposedly diversified basket of stocks performs. And more importantly than that is that we can sit around and we can debate whether you should own this or whether this is prudent. But more and more fiduciaries, more and more risk managers, more and more institutional portfolio managers are looking at it and saying this is dangerous and they're looking for ways around it. And one of the things that many of these managers are bumping up against is, is that although The S&P 500 is actually in line with this following rule of this thing called the 25, 5 50, which means that no one stock can have more than 25% and the five stock, the biggest stocks that are over 5% can't add up to more than 50% of your portfolio. That, that's an IRS rule. That is. It's called the 25, 550 rule. There's no problem with the S&P 500 currently with that rule, but there is something called the Russell 1000 Growth Index. And increasingly more and more institutional managers are benched to that index. And what we're seeing is within that index, we're bumping up against that. And what's happened now is that Russell has realized that this isn't just kind of a fiduciary point of view. This is actually an IRS issue in terms of they cannot go over those things. So what we're seeing is there's changes in the rules coming to make sure that this index is capped.

[Joe Weisenthal]

By the way, Tracy, Kevin, mentioning how exposed everyone is to AI beta, so to speak, and I just want to give a plug. We had a really good contribution in the Odd Lots newsletter from a skanda recently on this whole thing. There's just both in stocks and the economy and the real economy, there's just this, like, we get. They. They better get this AI thing right.

[Tracy Alloway]

Yeah, seems kind of important. Kevin, you mentioned finance professionals reacting to this concentration risk. So, okay, maybe your average mom and pop retail investor doesn't realize that The S&P 500 is not, you know, 500 equal weighted stocks, but certainly finance professionals do. And they're aware of both the risk involved in having a large concentration in just a handful of stocks and also some of the requirements around diversification. So legal requirements that you just mentioned. Before we get into some of those changes, can you maybe just give us a little bit of background on the importance of the index providers to the finance industry itself? This is sort of a pet topic of mine that I've written about occasionally, but how big a deal are the index providers now?

[Kevin Muir]

Well, you're absolutely right to highlight that, Tracy, and I'm glad to see you have such an enthusiastic traction to index providers. I'm the only one, you're the only one that gets excited about it. But it is a big story. And one of the issues is that as indexing has become more popular, some of the kind of traditional, the first of the indexers have started charging more, which has created an opportunity for other index providers to jump into the loop. So obviously we all know the S&P 500, but then there's the FTSE, which is Russell. But there's also things like Morningstar. And even you guys at Bloomberg have a lot of great indexes and you're competing on a lot of these things as well. So what's driving that is kind of two factors. One of them is that there is the cost associated with the big ones. So they're just trying to clients that have to pay tens and hundreds of thousand dollars for this index data is are changing providers trying to get something cheaper. And then the other thing is it's a little more kind of nefarious. There's some indexes that are easier to beat. So if you have an index that you know the rules, you can actually front run them. One of the when I was researching this and learning about this, someone told me that it's important that you buy the products of the indexes that are difficult to beat. And then from a kind of client perspective, you choose, if you are a portfolio manager, you choose the indexes that are easier to beat. Because if you're using, for example, the S&P 500 as your benchmark, that's a lot more difficult to beat than another index that might have one annual revision that is easy to kind of forecast and run ahead of.

[Tracy Alloway]

Joe, I should just mention Kevin was kind enough just then because he's a very polite Canadian to basically do our disclaimer for us, which is that Bloomberg lp, the parent company of Bloomberg News, does own a bunch of different indices, but probably most prominent among them are the Bloomberg bond indices and those were the Barclays indices before. So I should just mention that.

[Joe Weisenthal]

There you go. Thank you, Kevin. And thank you.

[Kevin Muir]

Can I jump in with just a little pro tip? Since a lot of people are getting Bloomberg users, One of the things is if you go when you want to see, for example, the index move in the S&P 500 and you type in HMOV, you'll see that they actually, unless you pay for that data, you don't get the index point changes. But Bloomberg has the B500, which is very similar, and you can plot it in and then all that functionality that you have to pay for on the other things, it actually works quite well on the Bloomberg indices.

[Joe Weisenthal]

There you go. So if you have a Bloomberg terminal but don't feel like paying for the S and P data specifically, Kevin just gave you a little bit of, a little bit of alpha there. You know it actually you talked about running index changes. Why isn't that easier? Right? Like S and P, they announced, oh, some new company is joining an index. How can you make money from those announcements?

[Kevin Muir]

Well, you used to be able to. There was a huge opportunity before and there was hedge funds that devoted themselves to doing it. But now everyone knows the ones that are due to go in. And then there's hedge funds who actually have portfolios of all the stocks that are due to go in. And even not just hedge funds, even pension funds will go out and front run them because they realize that there's some alpha there. So at the end of the day, Joe, the problem is that the more people look at it, the less money there is to be made in kind of trying to guess those things.

[Tracy Alloway]

All right, so let's get into how not just the benchmark index providers are reacting to increased concentration, but also how finance professionals are. You mentioned the Russell 1000. So give us a little bit more detail on what's happening there. So Russell1000 is aware that there's intense concentration risk, right?

[Kevin Muir]

So they're jumping. So they are actually getting ahead of their problems of potentially going and bumping up against this 25, 550 rule. And for those who are don't. Aren't aware of it, this isn't a new phenomenon. We actually had this in the summer of 2023 when Microsoft became too large of a position within the QQQs and there needed to be an emergency rebalance where they reduced the size of Microsoft. And then we also saw this in the Sector Select XLK Spider where Nvidia ran up and it actually ended up again. We bumped up against that 25, 550 rule and there needed to be an emergency rebalancing there. And that was a situation where there was the way that their capping worked. It was this kind of very violent shift from selling Apple and buying Nvidia and then kind of the next quarter flipped the other way because of the way that the stock prices moved and they had to do this rebalance again the other way. And so this is the problem with that, that many of these index providers are kind of bumping up against in terms of they don't want to be too violent with their shifts. They don't want to go and get into situations where they're rebalancing all the time trying to keep within this limits. And that is why the Russell in this R1000 growth, which is one of the most popular growth indexes out there, they chose instead of using the five and the 50 rule, they used four and a half and 45, meaning that any stock above four and a half, if all those stocks add up to 45%, then they do this rebalance. So they've kind of given themselves a little bit of extra, you know, room there in terms of the rebalance. What's interesting is that they had announced this, I don't know, it's a year ago because they saw this problem coming. Nobody was talking about it.

[Tracy Alloway]

Oh yeah. I actually went back to try to find articles on this. I couldn't find any.

[Kevin Muir]

Yeah, the way that I came upon this idea and this kind of revelation about that this is coming up was actually one of my subscribers and a buddy sent me something from Kevin Che from Discipline Alpha and he'd written this whole piece about it, just highlighting it. One of the reasons that he highlighted is he was a mid cap manager during the 2000s and he distinctly remembers Siebel Systems. And another one, I can't remember the other one, but there was two big stocks in the S&P 400 that were due to go into the S&P 500. And when they did it, the trouble was that the guys had all bought it for the S&P 500. And then when the S&P 400 guys went to sell it, there was no bids. And that coincided with the top of the NASDAQ market. And he's very kind of adamant that this is could be another situation where we have a situation where the Mag 7 has to go down in waiting in one of the biggest indexes out there. In terms of after the S&P 500, this is probably the next biggest growth index out there. And when this rebalance occurs, which again is in March, ironically, it's the same deal, there's going to be millions and millions of shares of these mag sevens for sale. And when I so for me, when I was trying to learn about it, I went and said okay, I went to an old buddy at TD and they were one of the few and I think he said he was the first sell side dealer to actually start talking about this. But increasingly over the last month, there's been more and more folks paying attention and realizing that this is a bigger deal than they realize.

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[Joe Weisenthal]

By the way, as Tracy knows, I love.com era trivia and talking about that and so like you talk about Siebel and you Talking about the 3Com Palm situation and all the. These are like, these are some of my catnip for. Yeah, this is total catnip. You know, it occurs to me like the sort of the very strict Chicago school, there's no such thing. People love to say there's no such thing as passive investing. You can sort of get close to it. The strict Chicago school people is like, you buy the global market portfolio at their market value. Every investable asset in the world. These rules essentially make it impossible, right? Because if you had some stock that was, I don't know, got so big it was 25% of the index or whatever, but you're not allowed to do it technically, like you really couldn't buy the true market portfolio given some of these constraints.

[Kevin Muir]

That's correct. And that's an IRS constraint. And then not only that, just stop and think about if you go and you try to recreate these portfolios at a broker. I spoke to one investment advisor. He said if I went and made a portfolio of the QQQs, like if I just made it from scratch and did all those things, that compliance would tell me that I'm too concentrated in tech stocks. So he says, I'm not allowed to buy this from a. From a compliance point of view, but I'm allowed to buy the clients qqqs. And that's back to my point is that we all just kind of been lulled into this feeling that everything's okay. It's. It's a broad index and it's no longer as broad. And ironically, you're talking about this idea about the indexing. And if you remember Mike Green and his theory that the big will get bigger because of indexing and more and more people will just continue and this will create a situation where the biggest stocks will continue to get bigger and bigger and bigger. Well, we're here. This is happening. And my pushback to that argument has always been that he's assuming the market doesn't work. He's assuming nobody goes and says, hey, wait, those stocks are too big. I'm going to go and no longer be benched to the s and P500. I'm going to be benched to Russell 1000 or maybe 3000, I'll change it. And see, this is the problem is that many clients have kind of career risk. So if they're benched to the s and P500, they can't go and put this huge bet where they don't own the Mag 7. Or they just say, nope, I can't own it, it's too expensive. They need to go and they need to own those stocks. But if you're a fiduciary that's managing money for someone and you go and you say, listen, this doesn't make any sense. We're buying this s and P500. And the original reason we did it was because it was supposed to be this diversified basket of the whole market. This no longer makes sense. Let's go try to find something else so you can change your benchmark. Now, ironically, that actually takes a lot of hassle and it's difficult. You have to go and you have to convince all the users of your product or the, or the end clients to switch it. And that is why in this situation with the Russell 1000 growth, instead of making a new benchmark that is capped, they said, no, we're just going to change the existing rules of the existing index. So if you want an unconstrained Russell 1000 growth, there is a new index that Russell has created. But in this case, it's going to be everyone that is the Russell 1000 growth. And it's a lot of them. Like, you go, you pull it up, you'll see 20 billion, 40 billion, lots of people with big, big accounts that are benched to this. They're going to all of a sudden find themselves overweight. Mag 7 Because there's a shift that's occurring on the March expiry, March 21st.

[Tracy Alloway]

So, Kevin, you mentioned Russell making this decision to change the existing index rather than create a new one. And this is exactly what I wanted to ask you about, which is, you know, when we talk about benchmark index providers, we talk about them as being passive, right? They, they always say they create these indices that are basically holding up a mirror to markets and trying to reflect them as they exist right now. And that kind of. I'm a little skeptical of that approach because I do think index construction affects things like flows. It's kind of reflexive. And I do think there are a lot of, you know, judgment calls that are embedded when you're deciding what to include and what to exclude. But if they're making an decision to change the weighting on something like tech, does that perhaps open them up to more scrutiny, perhaps from regulators?

[Kevin Muir]

Well, I wouldn't say from regulators. It's more scrutiny from the clients. But in this case, they're not actually saying they don't want more tech. They're saying we need to comply with this 25, 550 rule, which is an IRS rule. It has nothing to do with with a decision that they think that the Mag 7's gotten too risky. The index providers are there to provide whatever index they think they can sell to their clients. If their clients want something, they're going to do it. And by that token, interestingly enough, we see the S&P 500 earlier this spring introduced a capped version of the S&P 500 which has individual stocks capped at 3%. Now here in Canada we've actually already listed an ETF based upon this index. But the reason that S and P has created that index is because there's a demand for it and ultimately the clients will drive it. And what I thought was so interesting about this whole development is that we're seeing index providers having to change their rules because of this 25, 5 50. Then we're also seeing institutional pension funds, endowments starting to question whether they want to continue with benchmarks that have such a large concentration. And this is combined with the fact that many retail don't really understand what they're buying when they buy the s and P500. So when I look at this situation and think about how this is going to play out going forward, I could make the argument that we're kind of at the peak of concentration here and that this is the market correcting what has become too concentrated of a market.

[Joe Weisenthal]

Going back to this idea that the big just keep getting bigger. And you mentioned some of Mike Green's theories and there is this view that some have that the funds themselves, the ETFs, the index funds, create this mechanical flows and that flows to the biggest stocks and they keep going up, et cetera, flows before pros as Tracy has coined it.

[Grammarly Ad]

Do you still have that in your.

[Joe Weisenthal]

Message 9 Tracy I think I do.

[Tracy Alloway]

But only because I'm lazy and haven't been bothered to replace it.

[Grammarly Ad]

But on the other hand, we're recording.

[Joe Weisenthal]

This January 22nd and one of the biggest stocks in the market, Apple, has significantly underperformed all year. So the QQQ the indices are up, but Apple is actually significantly down this year. Concerns about iPhone sales it still looks to me that maybe there is some mechanical flows going on, but there is individual security selection and marginal price setting still happening. So despite all these, the flows that on some level if a company is if there are concerns about a company's performance, it doesn't just mechanically go higher.

[Kevin Muir]

You're right Joe, but I would push back and say that I'm Cliff Asness camp that it's become a lot less efficient, there's less and less fundamental investors going out and actually buying and selling stocks based upon fundamentals. And not only that, Cliff won't tell you this, but if you think about it, part of the reason the market has become less efficient is because of quants themselves. They become a larger and larger portion of the trading in the market. These pod shops, and I have nothing against them, they're producing some absolutely stellar returns, risk adjusted, they're out of this world, they're terrific. But a lot of it is based upon following momentum and doing things like earnings revisions and other kind of pro, like short term pro cyclical movements. So there's very little of the kind of David, the old David Einhorn. I'm buying a stock because it's for, you know, a 4pe and I'm planning on selling it at 7pe when everyone figures out that earnings are going to be better than expected. Now it's much more. Next quarter's EPS is going to be slightly higher. That means the earnings revisions tick up and therefore all of our models mean that you need to buy and everyone rushes into it and then the CTA falls and it just ends up feeding upon itself. So I'm not quite sure I completely agree with you, Joe, that everything is great with the markets. It really does feel to me like it's become less efficient, not more.

[Tracy Alloway]

All right, Kevin Muir, I am so glad that we finally got you on the show and we have to do it again. Thank you so much.

[Kevin Muir]

My pleasure. Thank you for having me on.

[Joe Weisenthal]

Thanks, Kevin. That was great.

[Tracy Alloway]

Joe. That was so much fun. I'm so glad we finally had Kevin on the show and he even brought you, you know.com era of feminine.

[Joe Weisenthal]

I know, I love it. I love this topic. I mean I, I just think about it all the time. I, I even wrote about it in the newsletter this week. Every month, bank of America does their hedge fund or their fund manager survey and one of the questions they ask is, what do you perceive as the most crowded trade? Basically, almost every month for years now.

[Tracy Alloway]

It'S been some version back in Fang.

[Joe Weisenthal]

Era, it's some version of big tech. And typically you think, oh, this is a crowded trade, it can't go on. But the move has been to play the crowded trade.

[Tracy Alloway]

Yeah, absolutely. And you're right, to some extent that's been justified by earnings. But I think, I think there is like this reflexivity that I mentioned at play in the market where, you know, the big attract more inflows, they get more capital, they get bigger, maybe they get more pricing power and then that leads to more earnings. So you have this sort of cycle going on.

[Joe Weisenthal]

I mean, for whatever reason, we are in an era. And I would say there is a winner take on this across the economy that you see for sure. And how much of that is financial flows, how much of it is real economic outcomes? I guess my inclination is still to look and say the earnings growth of these names are unbelievable. But whatever the reason, everyone is now all in on the same bet. And Kevin made the point about career risk, which is really key, which is that even if you think you've identified something else or maybe a better way to diversify, et cetera, do you really want to be the one person who like, oh, I'm going to like shave down my Nvidia exposure, or do you just want to ride with everyone else at the same time?

[Tracy Alloway]

You know, one of my favorite benchmark controversies is there's actually a lot of them if you think about, you know, like including Chinese bonds, including Chinese shares and things like that. But there was this big kerfuffle among Frontier and EM investors about Kuwait.

[Joe Weisenthal]

Huh.

[Tracy Alloway]

Kuwait was included in the MSCI Frontier index for the longest time and a lot of people didn't like that because Kuwait is this like fairly small country with only 4 million people and like a pretty small GDP. And everyone was like, why can't we have more Vietnam? Or something like that. So eventually they, they kicked weight out of the Frontier index and sent it to em and everyone was happy.

[Joe Weisenthal]

That's a good story.

[Tracy Alloway]

Kuwait, presumably.

[Joe Weisenthal]

That's a good story.

[Tracy Alloway]

Yeah. Thanks. Shall we leave it there?

[Joe Weisenthal]

Let's leave it there.

[Tracy Alloway]

All right. This has been another episode of the Odd Lots podcast. I'm Tracy Alloway. You can follow me at Tracy Alloway.

[Joe Weisenthal]

And I'm Jill Wiesenthal. You can follow me at the Stalwart.

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Follow our guest Kevin Muir.

[Joe Weisenthal]

He's Kevin Muir. Follow our producers Kerman Rodriguez, Ermenarman, Dash O'Bennett at Dashbot and Kell Brooks. And Kell Brooks. For more Odd Lots content, go to bloomberg.comoddlods where we have transcripts, a blog and a newsletter and you can chat about all of these topics including index concentration and markets and investing in our Discord, Discord, gg oddlauds.

[Tracy Alloway]

And if you enjoy Odd Lots, if you like it when we talk about benchmark index providers, then please leave us a positive review on your favorite podcast platform. And remember, if you are able Bloomberg subscriber, you can listen to all of our episodes absolutely ad free. All you need to do is find the Bloomberg channel on Apple podcasts and follow the instructions there. Thanks for listening.

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