CAP STRAT’s Will Woodall and Mike Rarey, CFA, bring you the most important headlines and investment insights this week. In this episode:

Nvidia joins the $1 trillion market cap club
Do valuations matter?
Understanding the top-heavy stock market
Plus an investment outlook based on inflation, liquidity, recession, and economic growth data

Email the CAP STRAT Team with any questions at researchteam@capstratig.com! Or call us at 630.320.5100.

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In recent years, the stock market has been characterized by a phenomenon known as “top-heaviness.” Put simply, this means that a relatively small number of stocks have driven the majority of the market’s performance. In other words, the top-heavy market is a scenario in which a small group of companies with large market capitalizations and market dominance affects the overall performance of the entire market.

For example, in 2020, the technology giants, including Apple, Amazon, Facebook, Microsoft, and Alphabet (Google), accounted for a disproportionate share of market gains. These five companies alone contributed to more than half of the S&P 500’s total return during the year.

The top-heavy market phenomenon is not new. It has occurred in prior market cycles, albeit with different companies leading the charge. However, it is essential to understand its implications, especially for investors.

One of the key implications of the top-heavy market is that it tends to inflate valuations for the leading companies. When investors flock to a few companies, pushing their share prices to dizzying heights, it can create a significant divergence in valuations between the market leaders and the rest of the companies. This divergence can lead to a situation where investors are paying a premium to own shares of the top companies, despite their growth prospects or earnings potential.

Therefore, it is essential to understand when valuations matter in a top-heavy market. Valuation refers to the analysis of a company’s financial metrics, such as price-to-earnings (P/E) ratio, price-to-book (P/B) ratio, among others, to understand if the stock is overvalued or undervalued compared to its peers, historical averages, or the overall market.

When it comes to top-heavy markets, it is crucial to assess the valuations of the market leaders, as they dictate the direction of the market. If the valuations are stretched and not supported by earnings growth or other fundamental factors, investors should be cautious, as a pullback can happen when expectations are not met.

However, when valuations are not overly inflated and supported by strong earnings growth and other drivers of future success, investors should consider owning shares of these companies, regardless of their market capitalization. After all, the strong get stronger, and these companies have a proven track record of success, innovation, and market dominance.

In summary, the top-heavy market is a phenomenon where a few companies dominate the stock market’s performance. While it can create significant investment opportunities, especially in the leading companies, it also poses significant risks, especially if valuations are stretched and not supported by fundamentals. Therefore, investors need to keep a close eye on valuations in a top-heavy market to make informed investment decisions and avoid pitfalls.