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Dangerous Imbalance Could Take Stock Market Down

It’s no secret: the stock market is doing very well right now. As we near the end of the year, key indices like the Nasdaq-100 are up close to 28%, people are loving those top stocks, and momentum is extremely strong, suggesting that there could be more upside ahead. This is great, if you have been bullish.

Here’s the thing though: it’s important to understand what’s really keeping the stock market up, and to keep in mind that there are some dangerous developments that are seemingly being ignored by investors these days.

Top Stocks vs. Underdogs: An Unhealthy Stock Market?

You see, a healthy stock market is when the majority of the companies are doing well.

Sadly, this isn’t really the case these days.

The indices are built in a way that the top performers and biggest companies have the most weight, and the lagging or smaller companies have the least weight. This phenomenon can sometimes make things seem rosier than they actually are.

Same Companies, Different Performance

Consider the chart below. It plots the year-to-date performance of Invesco QQQ Trust (Nasdaq: QQQ) and Direxion NASDAQ-100 Equal Weighted Index Shares (Nasdaq: QQQE).

Just so you know, both of these exchange-traded funds (ETFs) own the exact same companies (the constituents of the Nasdaq-100), but QQQ is built just like the Nasdaq-100 index and QQQE gives each company of the index equal weight.

Chart Courtesy of StockCharts.com

Notice something odd on the chart?

QQQ is outperforming QQQE by a very large margin. The indices are home to the same companies, but just at different weights. This is the major disparity within the stock market that I’m talking about.

Now take a look at how big this disparity has gotten over the past 10 years.

Chart Courtesy of StockCharts.com

The disparity has become severe over the past decade. QQQ performed almost twice as well as QQQE. Once again…the same companies, just different weights.

What’s Ahead for Top Stocks & the Market?

Looking at this disparity, should one be concerned?

Dear reader, I have learned that, in good times, no one wants to question what could go wrong. When the stock market crashes, everyone says, “We didn’t see it coming.”

The reality at the moment is that it’s only a small number of companies—those top stocks everyone adores—on the stock market that are actually making the returns look good.

For some perspective, consider this: the top seven companies on the Nasdaq, dubbed the “Magnificent Seven,” account for around 50% of the index’s weight. A lot of money is also pouring into the same stocks—they are the hottest things in town. It has gotten to a point that if you don’t own the top stocks, your portfolio performance is really lagging behind everyone else’s.

I just have to wonder: what happens if just a few of the top stocks on the stock market were to show weakness or shareholders were to decide to just take profits?

During the Global Financial Crisis of 2008–2009, there was this idea of “too big to fail” banks. Everyone bought into the idea that banks needed to be saved at whatever the cost or else they would become a systematic problem, leading to a much bigger financial crisis.

I wonder if the same sort of logic can be applied to the top stocks on the stock market these days: are they too big to fall? If they do fall, would a stock market crash?

I will end with this thought: if the big stocks were to take a nosedive at some point, for whatever reason, investors selling those stocks could start looking for new places to park their money.

There’s a lot of value out there that’s relatively ignored, so I wouldn’t be shocked if the stocks of companies with good businesses, strong balance sheets, great management, and lagging stock prices were hastily bought up in that scenario. And investors who already own those “underdog” stocks could reap the benefits.

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