Passive Investing Could Be Very Costly. What’s Your Plan if a Market Correction Strikes?

Executive summary:

  • The price-to-earnings ratio of the Magnificent Seven is not yet at levels seen during the 1999 tech bubble, but historical observations can elude forecast accuracy.
  • The S&P 500 Index today is the most concentrated it's been since the 1950s. Amid this backdrop, taking a passive approach increasingly exposes investors to a few high-flying securities—and may lead to significant portfolio drag if these stocks begin to fizzle.
  • We believe a diversified, multi-manager approach can best help manage the risks of investing in today's highly concentrated markets.

Material tail risk appears for passive investing in the current landscape

How long will the Magnificent Seven group of stocks stay magnificent? Are cracks starting to appear in its armor?

The consensus outlook among analysts today is that tech innovation will rewrite the global productivity index, with AI (artificial intelligence) and automation expected to bring a new wave of industry efficiencies. Because each of the companies in the Magnificent Seven are tech innovators, some have speculated that this group could dominate the stock market for years to come. And while this may or may not prove to be the case, it's important for investors to understand that the fundamentals of investing will remain the same regardless. Simply put, price points still matter and valuations ultimately will determine the magnitude of investment returns—and inform the margin of safety behind a decision.

Party like it's 1999? How today's market concentration compares to the dot-com boom of the 1990s

The market dominance of the Magnificent Seven today is reminiscent of Cisco and Microsoft in 1999, which was the last time similar extreme levels of concentration occurred among the biggest index members of the S&P 500. Microsoft, for example, peaked at US$60 per share in 1999 before the dot-com bubble burst. The company would not reclaim this price point for 16 years, as the chart below shows.