The Risks To The Index Right Now Are Obvious

Mike Santoli posted a thread on Bluesky that included the following about the staples sector.

I think the longer term trend on the chart is more about the growth of tech and other growthy sectors as opposed to something bad going on with staples. The reasons to own staples include the tendency to have lower volatility, smaller drawdowns during market turmoil and a higher dividend yield than the broad market. The negatives include having a lower growth rate and depending on the circumstances, they have interest rate risk. 

A portfolio that goes narrower than broad indexes should probably have some exposure to the sector. 

Santoli's comment about being too defensive in staples is interesting. Let's see what that looks like though over a very long time horizon. 

Portfolio 5 obviously plays around with barbelling volatility and the growth rate with a nod to capital efficiency. The 2X tech ETF is ROM but as we've been describing it lately, instead of thinking of ROM as being 2x, it might be more useful to think of it as technology plus the volatility of the tech sector.

The result of Portfolio 5's backtest is of course compelling versus a more plain vanilla version of 60/40. Actually putting 55% into one sector fund is terrible portfolio construction but the bigger point of managing volatility inside of a properly diversified portfolio is valid. 

That brings us to Jason Zweig's latest in which he says indexing has become an "extreme sport." His big picture point of keeping things simple and the difficulty of picking stocks, narrow themes or otherwise chasing heat successfully is hard to argue with.

Lost in the article though is that large cap market weighted index funds have plenty of drawbacks. The rides down can be brutal and compounded by the common belief that this one is different even though it's never different. 

It's easy to extoll the virtue of market cap weighting when the market is close to an all time high but under the hood of the market right now is an enormous weighting to tech + communications with a heavy emphasis on the AI theme. The actual internet turned out to exceed the hype of the stocks in the space 25 years ago but the vast majority of the stocks capitalizing on that hype quickly disappeared. Actual AI could also exceed the hype but will there be the same destruction of stocks as was the case 25 years ago?

I have no idea but regardless of whether there is a similar fallout or not, loading up on the S&P now takes on the full brunt of the risk that very few of today's AI leaders will still be the leaders five years from now. 

If you weren't in markets 25 years ago or don't remember, sitting on the mountain top of early 2000, that these four stocks would compound negatively for the next ten years was unfathomable. Maybe even more unfathomable was that AOL wouldn't exist. Right here right now, it is again unfathomable that companies like Nvidia, Microsoft, Broadcom and Meta could compound negatively for the next ten years but if it happens, then hold on no matter what to nothing but the index will be in a lot of trouble. 

That scenario could be good for younger accumulators but anyone close to or already living off their portfolio would have a real problem. Maybe you disagree with my idea of a lot of simplicity hedged with a little complexity but the risks to the index right now are obvious even if there is never any consequence of the risk.

That's why we spend so much time looking at ways to capture a decent chunk of the upside while trying to diffuse whatever the prevailing risk might be. 

The information, analysis and opinions expressed herein reflect our judgment and opinions as of the date of writing and are subject to change at any time without notice. They are not intended to constitute legal, tax, securities or investment advice or a recommended course of action in any given situation.