XLG: The Bigger They Are The Harder They'll Fall

TERADAT SANTIVIVUT

The Invesco S&P 500® Top 50 ETF (NYSEARCA:XLG) tracks the show of the S&P 500 Top 50 Index, which is composed of 50 of the largest companies successful the S&P500. It whitethorn astonishment galore to cognize that ample and mega-cap stocks person underperformed implicit the agelong word owed to slower net maturation than the broader market. This makes their existent valuation premium peculiarly concerning. While the past 2 large equity carnivore markets successful 2008-09 and 2020 saw mega caps outperform, the adjacent downturn is apt to spot the XLG underperform.

The XLG is adjacent much heavy skewed towards costly Technology stocks than the wide market, with a 38% weighting compared to 28% for the S&P500. The money charges an disbursal interest of 0.2% resulting successful a nett dividend output of 1.0%. The apical 50 S&P500 stocks present marque up a grounds 57% of the wide S&P500, and 84% of the S&P100.

S&P500 Top 50 Index Market Cap, % of S&P500 and S&P100 (Bloomberg)

The Mega Cap Premium Is Not Normal

While I lone person cardinal information connected the S&P 500 Top 50 Index going backmost to 2017, it is harmless to accidental that its existent valuation premium is not normal. The pursuing illustration shows the P/E ratios of the U.S. markets by size, from the S&P500 Top 50 to the S&P100 to the Equal Weighted S&P500 to the S&P400 Mid-Caps to the S&P600 Small Caps.

PE Ratios (Bloomberg)

For astir of the past 2 decades extracurricular of the post-Covid bubble, larger U.S. stocks person traded astatine a discount to smaller ones owed to their slower maturation potential, which is simply a relation of marketplace size. Since the Covid crash, determination has been a large reversal successful show and valuations, with investors paying up for the perceived information and maturation of the largest stocks successful the country. The S&P500 Top 50 Index present trades astatine a P/E ratio of 26x, compared to 18x for the median S&P500 stocks and conscionable 16x for tiny and mid-cap stocks.

This mega headdress valuation premium is adjacent much antithetic erstwhile we see that nett margins are besides considerably higher than their peers. With operating margins astatine implicit 18%, treble the Equal Weighted S&P500, the precocious P/E ratio is intelligibly not the effect of impermanent declines successful profitability.

Operating Profit Margins (Bloomberg)

Retail Traders Amplify Busts As Well As Booms

The emergence successful appetite for mega caps stocks whitethorn beryllium explained by the emergence successful retail investors arsenic a stock of the market. The proliferation of retail traders since the Covid lockdowns, peculiarly successful the options markets, seems to person been a cardinal operator of this anomaly successful mega headdress comparative valuations. Retail investors thin to prime stocks based connected sanction recognition, and truthful people this would payment mega headdress stocks. These investors thin to beryllium driven by humanities performance, pursuit markets that person already risen frankincense expanding their outperformance, but by the aforesaid token they are much apt to merchantability connected weakness. As we saw successful the late-1990s, retail investors drove up tech stocks mode beyond their fundamentals and past panic sold them arsenic the Nasdaq 100 fell 83% from its peak.

While the largest S&P 500 stocks person tended to outperform during recessions, the existent carnivore market, which began successful January 2022, is apt to beryllium peculiarly harsh to these wide loved stocks. Higher nett margins and stronger equilibrium sheets person tended to let mega headdress stocks to outperform the broader U.S. marketplace during times of recession and fiscal crisis, arsenic seen successful 2008/09 and 2020. While these are inactive factors that should enactment mega caps successful different carnivore market, their utmost valuation premium driven by retail investors volition marque outperformance precise difficult. As we saw successful the early-2000s carnivore market, the mean S&P 500 banal outperformed the S&P 100 by implicit 60% arsenic the celebrated names crashed portion the mean banal managed to execute reasonably well.

Ratio of Equal Weighted S&P500 Over S&P100 (Bloomberg)

A Lot Has To Go Right For XLG To Outperform

With the apical 50 trading astatine a P/E ratio of 26x versus 18x for the little 450, this means that investors successful the XLG necessitate net to emergence by astir 50% connected a comparative ground to warrant the existent valuation premium. With inequality an progressively blistery governmental issue, adjacent much of the country's scarce savings successful the hands of a fewer ample companies and their shareholders is apt to summation calls for redistributive policies targeting large companies. It would besides rise the hazard of an summation successful protectionist policies aimed astatine supporting bluish collar workers. We are besides apt to spot accrued pushback against AI driven automation and its interaction connected little skilled workers, portion governments volition apt usage specified exertion to tighten their grip connected nine globally, retarding the productivity benefits of AI. While this does not mean that mega headdress stocks and the XLG cannot proceed their outperformance, it does mean that a batch volition person to spell close for this to occur.

I americium a full-time capitalist and proprietor of Icon Economics - a macro probe institution focussed connected providing contrarian concern ideas crossed FX, Equities, and Fixed Income based connected Austrian economical theory. Formerly Head of Financial Markets astatine Fitch Solutions, I person 15 years of acquisition investing and analysing Asian and Global markets.