The S&P 4

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According to MarketWatch,

Just Apple, Microsoft, Amazon and Google account for 21% of the [S&P 500] index.

Some very important economic analysis was developed without taking this possibility into account.

Consider portfolio theory. The idea is that you diversify by holding the market portfolio. But if the market portfolio is itself not diverse, what does that imply? My first thought is it you should require a higher expected return.

Consider industrial organization. Economists usually measure market power by looking at a firm’s share of market sales. But should share of market capitalization be an indicator? Does Amazon’s share of market capitalization in retail predict its future share of market sales in retail?

9 thoughts on “The S&P 4”

  1. Why should we only consider the market value of equity for understanding market power? There are many firms with vastly more assets than these firms because they make heavy use of debt. For example, JP Morgan Chase is more than $2.5 trillion I’m total assets, about 90% debt funded, but vastly bigger than Apple’s $375 billion. Even if we exclude banks,

    If we redid your calculation, but did it based on the enterprise value (debt + equity) of the S&P 500 firms, we’d find this percentage drop substantially, because these four firms use almost no debt.

    Rather than being a criticism of portfolio theory, portfolio theory seems to be warning us of the dangers of being solely invested in an ETF of the S&P 500.

    • Great comment! I addressed a couple of your points in my longer post below.

  2. The “market portfolio” concept is a really nice concept around diversification and alignment to the broad economy etc etc….. but ….

    ….we have problems…. and frankly the concentration of big stocks in SP500 is actually a trivial issue compared to the more significant issues that the SP500 itself represents only a tiny % of the true “market portfolio” of all possible assets (which the concept relies on). First, between unlisted equity (eg shares in small business, private companies, venture capital etc etc), debt assets (loans held by banks, debt securities that are practically difficult for an investor to secure), and unlisted property assets, well a huge chuck of investment alternatives is essentially out of possibly for most investors. And the above are only some of the more significant categorise. The S&P 500 is small subset of the the practically investable asset universe, which itself is almost a trival subset of of the true “market portfolio” in it’s pure concept form of all assets

    Then we have problem number two…. the asset of PV of human capital…. this is both the largest asset class aggregate in the modern economy, while also being the most significant asset in the ‘portfolio’ of most people…. and it is close to completely impossible to invest in.

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    However, despite those huge practical problems with the “market portfolio” as a concept, it can actually be recovered with some loosening of the perfection constraints quite easily…. as Ray Dalio ($40bn net worth hedge fund manager) nicely points out in a short youtube video, one actually only need to invests in quite a small number of lowly correlated assets to achieve the vast majority of risk benefits of portfolio theory – there is limited and diminishing marginal gains to further diversification (in terms of portfolio risk-reward frontier) beyond a certain point – and certainly the benefits will be small enough that transaction costs outweigh them. There (likely) is a sufficiently diverse (decorrelated/low correlation) set of investable options out there that an imperfect-but-good-enough “market portfolio” can be practically achieved and thus the insights from “market portfolio” theory may still have some validity for some people…. (see below)

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    The biggest issue with the whole theory that i see is that it is near impossible for the vast majority of people to actually diversify away from their PV of human capital asset class, which forms their largest asset. For the financially wealthy or retirees where this asset class is immaterial, it doesn’t matter, financial assets is what matters. But how does a young person with high human capital but low financial capital even remotely get access to the benefits of diversification via the “market portfolio”? Where and how they invest their financial capital is essentially immaterial to the risk characteristics of their entire portfolio….

  3. Given that the next administration endorses Tyler Cowen’s proposal to abolish the shareholder wealth maximization in favor of stakeholder capitalism in which earnings are to be distributed to politically favored lobbies, I’d have to say everything that is known about equity can be thrown out the window. With the expectation that earnings will be increasingly diverted to non-shareholder interest groups, share prices may or may not take into account reduced investment and reduced dividend potential. Will Apple and Microsoft even continue to pay dividends? When will the rush to debt investments begin?

    By investing in the various domestic terrorist paramilitary groups aligned with the Democratic Party, Amazon has demonstrated one way stakeholder capitalism can advance corporate value: getting your small business competitors burned down. But Amazon these days is less about retail and more about government cloud computing contracts. With no dividend prospects in sight, the only reason Amazon shares have a price at all is its inclusion in index funds. Renegotiation of USPS rates may cut into its retail share as will Shopify and others taking advantage of the opportunity presented by Amazon taking such a huge cut of its vendors sales. Amazon is also heavily dependent on China so big risk there in the reaction to China’s impending invasion of Taiwan.

    Apple faces similar risks with China. They really need to invest in supply chain resilience.

    I dumped Microsoft Office for Livre Office a year ago and am glad I did. Don’t see much upside in Microsoft software.

    Alphabet/Google has yet to pay a dividend but appears to be so diversified into countless product lines that it is impossible to keep track of them all. Looks like a typical pre-market-for-corporate-control multinational except nobody is interested in buying. Cheaper and easier to compete by starting from the ground up. Probably has a few years left.

    Anyway, you make a good point: S&P index funds are toxic. Debt index funds look like a better long-term investment.

  5. Covid is a horrid Black Swan. Black means the priors have been wiped out, no valid recent history.

  6. I think that Matt Stoller would argue that the fact that these four companies make up such a large proportion of the index suggest that they have too much market power and function as monopolies. I’ve been meaning to ask Arnold if he reads Stoller’s essays, which primarily focus on market concentration. An excellent example is here and a very funny one here.

    Thank you to OneEyedMan for making a very good point about banks having so much debt and the big for having large cash reserves. First, I’d suggest that the fact that these companies have so much cash suggests they’re monopolies, if you assume that in an efficient market they’d face pressure to spend cash reserves on research or hiring or advertising or any number of other things.

    Continuing on the anti-monopoly theme, I’d note that banks are supposed to be an institution that increases competition by lending to many borrowers, and when any single firm starts to be larger than the banks, that is another indication that these firms are operating as monopolies, if you assume that in an efficient market banks would make loans that allow multiple firms to compete for a share of potential earnings in any given market.

    Of course I hope smarter people than me will challenge those two assumptions, especially because if they’re mostly true, it suggests that our nation’s economy is mostly not great.

    • That should read “big four,” not “big for.” I keep forgetting this comment system doesn’t let me fix typos after hitting post, which is one of my oldest habits.

    • Monopoly means “one seller”. There’s a very easy way to tell if there’s a monopoly: is there one seller or more than one? These markets are obviously not monopolies.

      What you seem to be saying is that they are not “perfectly competitive”. If so, you are, of course, right.

      Some relevant questions than are why the markets are the way they are and whether (and how) they could better.

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