Big Tech Concentration: The Media Got the Problem Right — But the Solution Wrong

Paul Winkler: Welcome, this is “The Investor Coaching Show.” I am Paul Winkler, he is Jim Wood hanging out with me. We haven’t even said hi.

Jim Wood: I am Jim Wood.

PW: No joking that we have not even said hi to each other because I’ve been running around like a chicken with my head cut off trying to get the technology here straight.

JW: Hi, Paul.

PW: Jim, how you doing, man?

JW: I’m doing good. Good.

PW: Yeah, good to see you.

JW: Yeah, good to be here.

PW: I’m looking forward to this. You don’t come on here Saturdays very often. This is going to be fun.

JW: Yeah, I’ve done a little better recently, but yeah, it’s good to be here for the full two hours.

PW: Well, yeah. Well, yeah. Well, I guess he has been a little bit better recently, but we’ll give you a pass.

How Will the Markets Respond?

PW: So yeah, so a lot of things always to talk about in the world of finance, and there are a lot of conversations that have been going on. We’ve got, of course, craziness overseas as usual.

And a friend of mine, he said something the other day, he said, “Did you see this happen?” And I was like, “Oh gosh, no. Okay. Yeah, no.”

But it hadn’t happened. It was this report about Russia, and it turned out to not be quite exactly what he was saying it was going to be, but it was one of those things where you thought, Wow, how will markets respond if something like that happens?

And then there were some reports of things that happened this week that were kind of negative, but markets didn’t respond at all. They actually went up.

And what that tells you is that all that stuff was built into stock prices, so that a lot of the things that we worry about, things that we’re going, “Oh my gosh, if this happens, how’s it going to affect markets?” A lot of the stuff gets built in.

JW: Yeah. I think that’s interesting. There’s a couple different sides of looking at that, and one is just the fact that reacting to real news. So you said that turned out to not be real, but reacting to real news and what’s going to happen, and like you said, it’s either priced in or you can’t react to it anyway. So we’re worrying about that day-to-day stuff; certainly there’s no point to it.

But then also reacting to news that turns out to not be true. And especially so many things like the Iran war and stuff, when stuff comes out or sometimes these tragedies, when there’s a shooting or something like that, the information that comes out first is completely wrong.

And so people are worried about it and think, How am I going to react? And then, well, that’s not exactly even the way that it turned out.

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So from an investing standpoint, reacting to news, real or fake, doesn’t serve you as an investor.

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PW: Yeah, it was funny because for years we had … I don’t think it’s in there anymore. No, I’m pretty sure it’s not, because I just taught the workshop the other day. We had that little headline of the White House bombing. Remember that?

JW: Yeah, oh, sure.

PW: We had the headline, and it showed the stock market, and it turned out to be a false tweet, and the market dropped like crazy, and then they found out it was false, and the market goes straight back up.

JW: Yeah, all in the course of an hour or something like that. It was just incredible.

PW: Yeah. And the point that we made in the workshop was that’s it. You’ve got to know the news before it happens.

JW: Yeah. Well, and then the flash crash was kind of an extended version of that.

PW: Yeah, yeah, yeah, I forgot about that one.

JW: It was just a bunch of automatic selling. I still remember sitting at my computer watching that in fascination as the market dropped 20% in less than an hour, and then right after that, I said, “Well, this is going to be an interesting day.” And before I went home, it was almost all the way back up.

Diversification Is Critical

PW: Yeah.

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One of the things that I’ve been thinking about is how diversification is critical before you actually need it. 

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And I find that so many people are getting complacent. They’re getting real comfortable. “Hey, the market’s been going up. When it did go down this year …”

When we defined the market as being, for most people, the S&P 500, that’s the market and that’s it. There’s nothing else in their mind other than the S&P 500, the NASDAQ, and the Dow.

And that’s what you hear reported, “This is what the Dow did today. This is what the NASDAQ is, what the S&P 500 did.” Large U.S. stocks, large U.S. stocks, large U.S. stocks, and that’s pretty much all most people think of.

And that’s the way things were in the late ’90s. I remember that you would have these reports on what was going on in technology and the internet stocks and those types, and it seemed like the sky was the limit. It was going to keep going up and up and up until it didn’t, and then other areas, actually, when that area dropped like a rock, other areas held just fine, but very few people were actually invested in those areas.

JW: Yeah. Well, it was funny, and it’s a story I’ve probably told before, but that was right when I was starting my career in financial services, the late ’90s, and one of the first things I owned was a small cap value fund, late 1990s, and so I had this fund, didn’t have much money or anything, but I had that. And then that was the time that all the Janus funds were doing good.

PW: Yeah, yeah, very heavy tech.

JW: Oracle, Cisco, Sun Microsystems, things were just shooting the lights out. And so I was mad that my small-cap value fund that I bought wasn’t doing anything because I didn’t understand any of the academics or anything. I was just brand new in the industry.

PW: Nor did you need to; you were just supposed to get out there and sell.

JW: Yeah. Well, exactly. And so what happened was I got frustrated with my small-cap value fund and put it all into this fund that basically was propped up by a cute wholesaler.

PW: Yeah. Demographics.

JW: A cute wholesaler that came in and talked to us about this fund, and it was the Harry Dent Demographics fund.

PW: Yeah, the Demographics fund.

JW: Which was hilarious.

PW: Yeah, it was super popular.

JW: And so I bought that.

PW: This seems like such a great idea.

JW: Over the next 10 years, the small-cap value fund did phenomenal, and the Dem fund lost 70%.

PW: Yeah, exactly.

JW: Something like that. Great lesson to learn out of the gate.

Diversifying Into Commodities

PW: Yeah. There was a little conversation that took place this week. It was about diversification. It was actually something I wanted to just talk about.

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Because diversification is something we talk about, but it’s like the weather: People talk about it, but they don’t do anything about it. 

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But just check out this little clip right here regarding diversification.

Speaker 1: As a matter of fact, and yeah, cost, Taiwan Semi is the biggest emerging markets index component, and I think it’s made it tricky to diversify in an effective way, you know?

Speaker 2: Yes.

S1: And I think increasingly you have a lot of people saying, “Bonds look a little scary, maybe yields have to go higher, fiscal situation, et cetera, inflation.” So why not use commodities in some fashion, either energy stocks or something else like that as your offset to tech?

PW: So there, what they’re talking about, they’re saying, like what we’ve been talking about, technology, real high price, been running for quite a while now and things have been pretty hot there. So how do we diversify? What was their answer?

Did you hear that? They literally diversified into something that was not an investment, is what they basically said, which is insane. “Let’s diversify into commodities. That’s a great idea.”

JW: Right. Well, and we talk a lot about academic evidence and commodities, to add that to the portfolio, it does not have the appropriate academic evidence.

To add it to your portfolio, that means it has to show that it’s either going to have a high, high chance, academically verified, lots of data that it’s going to either increase your return or lower your risk or both. And commodities don’t have that.

PW: Yeah, you want evidence.

JW: Yeah.

PW: You invest based on evidence. You don’t invest based on what somebody on TV tells you.

JW: Right, right. Well, you can say an argument that sounds plausible, and if you don’t know any better, then okay.

PW: Oh yeah, yeah, yeah, sure.

Taiwan and China

PW: Of course, talking about Taiwan, you’re always worried about, When’s the shoe going to drop? Is something going to happen with China with regards to that?

Because there’s quite a bit of desperation, and I’ve heard this for years, so it’s nothing new. And people act like it’s new that China is in difficult straits. Straits, I didn’t even think about that. No pun intended, Strait of Hormuz.

But they’re in a difficult position just simply because economically they’ve got a ton of debt. For years we’ve known that they’ve had these apartment complexes that nobody’s in them.

They’ve been spending money like drunken sailors — no offense to drunken sailors — but they have a ton of money going out and they don’t have a lot of money coming in. And as a result of it, you have a situation where they’re in some financial difficulty and some economic difficulty, and now we’re looking at, are they going to want to go to one of the hottest countries on the planet because of their semiconductors, Taiwan, to bail themselves out of that?

And that was one of the things at the talk. Remember when they had that meeting with President Trump, it was like, “You’re not going to bother us regarding Taiwan, are you?” Kind of was what the conversation was.

JW: Well, then the negotiations on that are ongoing, and I think we’ve probably stated our position pretty well on that Taiwan isn’t up for grabs. China, of course, position is —

PW: Well, they don’t like that position.

JW: — they want to grab it.

PW: They don’t like that position at all, Jim.

JW: And just it’s always for every side it’s going to be cost-benefit, you know?

PW: Right, right.

JW:

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What’s the benefit if they go in there and invade Taiwan, and then what’s the cost to them to do that? 

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Do they get away with it? Do they not?

Needing Exposure

PW: Right. So the female host, she had her response, and I thought I’d have you check this one out.

S2: Yeah, I hear all the time from investors this question about diversification and just the difficulty of getting that. That had been a big selling point of the private markets recently, this idea of “the public markets are so concentrated, you should have private market exposure, you should have international exposure, you should have commodities exposure, more fixed income exposure,” but that’s obviously a little tricky over the last few weeks as well.

So I know that’s top of mind, especially in light of diversifying. Recently, you’re missing out on losses if you’re not really all in on the AI trade, which has been the biggest beneficiary.

S1: Right. Nobody wants to hear it, but lots of parts of the market are starting to look really cheap and neglected and washed out, right? You want to talk about consumer staples, you want to buy Campbell Soup at a 30-year low?

Speaker 3: Thirty-year low, yeah, that was interesting yesterday on CPB.

PW: Yeah. Okay. So a couple things. I don’t know what you picked up on that, Jim, but you go first, and I’ll take it after that. What are the things that you got out of that?

JW: Well, you need a lot of exposure, apparently.

PW: What’s that?

JW: You need a lot of exposure, apparently. You need this exposure, you need that. You need a northern exposure.

PW: Yeah, exposure to what, though? You hear what they said to expose to was private equity, number one.

JW: Yeah, yeah, of course.

PW: That was the first thing that hit me. And why? Why expose yourself to private equity?

Now this is something that is important to those of you out there with 401(k)s, because this is something that the investment world wants to start to move you toward.

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They haven’t been able to charge enough fees for the typical investment asset classes that you might want to own. 

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And because they haven’t been able to charge enough fees, they’re looking for things that are more expensive because, hey, that’s how they make money.

Adding Private Equity to 401(k) Plans

PW: So the investment industry has been more driven to add private equity to 401(k) plans. The government’s been basically giving the go-ahead, but the reason that they said in there, if you pay close attention, that they’re going to add private equity was because the number of public companies has been diminishing.

Now, if we look at that and we say, “Oh, that makes sense. So if you have all of this money, but you only have so many public companies, that could be a problem.”

But there are a couple of things that are missing there. Number one, if you think about the number of public companies, some of those public companies have diminished in the United States, where we’ve had increases internationally in the number of public companies, and if you’re not diversified internationally, yeah, that might be a problem. Number one.

Number two, what is also going on around the world that creates less demand for goods and services? Well, the diminishing of the number of people around the world because of birth rates, number two.

Now, number three, think about it this way as well. Just because there are fewer companies, does that necessarily mean that companies have to pay less to use your money?

Because that’s what they’re implying as to why you have to go into these other areas, because these companies aren’t going to perform as well. That doesn’t make any sense whatsoever.

When we deal with risk and return, there is more return when there is more risk, and the reality of it is if you have this diminishment and you have these other countries around the world that are competing with us, that increases risk. And historically, what we know from the research, this isn’t just Paul making up something.

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We know from the research that when there is a greater risk of anything, returns historically have gone up. 

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If we look at the periods in history when returns have been highest in the stock market, it has been the periods of highest risk.

The First Bond Ever Issued

PW: Matter of fact, there was a study they’ve done on the prestiti. The prestiti was the very first bond that was ever issued.

And the idea was that the government was looking at, in the Roman Empire, they were looking at ways to actually raise money, and they issued bonds, and they forced wealthy people that had money, they forced them to lend money to the government at that point in time. Now the interesting thing is this goes back a couple of thousand years, and they literally have data on this investment where what happened, this is something that Fama, the guy that won the Nobel in 2013 actually taught us, but he basically said this.

He said, “The government actually tracked this stuff, and they actually have data on the returns of these things. When the Roman Empire was at its peak, when things seemed to be the most safe, the rate of return on the procedure was actually at its lowest. When things looked a little bit more tenuous, that’s when the return was actually higher.” So it goes against logic when I look at it that way, Jim.

JW: 

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Well, one of my favorite phrases to teach investors is that risk and return are related. It’s so simple, and it explains so much.

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It explains why we build the portfolios the way we do, leaning toward areas of the market that by themselves have higher risk, value small, but by blending together in the proper way, you can diversify away much of that risk, long-term increase your expected return at lower overall risk. And that just is something to help them understand that there’s no free lunch, right?

PW: Right.

JW: You get paid the returns of equities long term precisely for dealing with that risk, then the short term they’re going to be variable. And so I love that phrase.

PW: Yeah. And when we look at this whole thing with academics and putting these things together, what I think is so interesting is that you take these areas that are riskier by definition. They look riskier, and they are riskier by definition, but when you put them together, it actually reduces the risk because they just don’t move together, and really, that’s the key, is just understanding that’s how markets work.

The SpaceX IPO

PW: You’ve been following the SpaceX Odyssey. SpaceX Odyssey. That sounds like a movie. We ought to call it that.

JW: Well, I see a lot of stuff on X, but what specifically?

PW: The IPO.

JW: Oh, okay. Oh, I’ve seen some talk about it. Yeah.

PW: Yeah. Yeah. The commercials.

There are all kinds of commercials. “How you can get in on the IPO, you can get in and on it early.”

And I’ve covered that the past couple of weeks, how there are a bunch of scams out there regarding that. Now, can you actually? Was there anything to that?

I talked about this significantly in previous shows, so I won’t cover it today. But, yes, there were some things out there talking about being able to get in on the IPO early, but you’ve got to get somebody else to sell, is the point that I made, number one.

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The reality of it: IPOs typically lose money, and then you have restrictions for getting back out of it. 

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You can buy it, but it’s like I kiddingly have said, it’s like the Hotel California. You get in, but you can’t necessarily get out.

So, just perish that thought. If you want to check out what I had to say about that, check back at the website, paulwinkler.com, for some previous shows where I talk a little bit more about that.

But anyway, the whole thing was being talked about this week regarding indexes. And if you listen to this show much, you recognize that we talk an awful lot about how markets work, not trying to pick stocks, not trying to time the markets.

And typically, what do people do? They think, Oh, you’re talking about index fund investing. Which is what we’ll see with a lot of the big mutual fund companies.

Fidelity has a ton of them. Vanguard has a ton of them. Most mutual fund companies, actually, and it’s funny because mutual fund companies do both.

It’s like, “Oh, you want to index? We’ll give you index funds. Oh, you want to stock pick and market time? We’ll give you active managed funds, and we’ll let you do whatever you want to do, quite frankly.”

JW: “We’d sell you crack if we could get away with it.”

PW: The opinions of Jim are not necessarily the opinions of … No. But, yeah, people typically think that’s what I’m talking about, “Just buy an index fund.”

Paul’s Opinion on Indexing

PW: For those of you who don’t know my opinion on that, let me just give it real quickly.

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Indexing works pretty well when it comes to large U.S. stocks. It works pretty well with large international stocks.

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But it doesn’t work in a lot of other areas of the market like small caps and value. And the reason is you’re overweighting the bigger companies. You’re overweighting the less value-oriented companies, and that’s the problem you run into with an index fund.

But there’s another problem. There are hidden costs in indexes that you may not be aware of. And one is called the reconstitution effect.

And the idea behind the reconstitution effect is that when companies are going to be added to an index or subtracted from an index, the index funds do not have tracking error, which means that they must move with the index. So when I talk about “index,” the S&P 500 is an index. It tracks the 500 relatively biggest companies in the United States.

You have the Dow Jones Index, which is 30 companies. You’ll have the Russell 2000, which are technically smaller companies, and Russell 2000 value, which are in the more distressed smaller value companies. Then you’ll have the Europe, Australia, Far East, and you’ll have different indexes around the world.

And they change from time to time, and they’re typically reconstituted on a regular basis when they are changed. Then, the index manager, whoever it may be, whether it be Vanguard, whether it be Fidelity, whether it be T. Rowe Price …

American Funds doesn’t do indexing. They love active management, which is what we’ve always preached against here.

But in effect, here’s the idea: They have to sell whatever is being removed from the index, and they must buy whatever is coming into the index. Well, what effect does that have when you have a change?

Well, it has the effect of driving down the price of the thing that is being sold, which is the company going out of the index, and then driving up the price of whatever it is that is being bought to go back into the index or to go into the index.

And that is the opposite of what you want to do. You don’t want to sell low, which is what they’re doing, and buy high, which is what they’re doing with that.

And that’s just a hidden cost. It doesn’t show up in the management fee of the fund at all and, therefore, it doesn’t show up on most people’s radar screens because that’s what people are looking at.

Enormous Demand From Index Buying

PW: Well, that’s what they were talking about regarding the new SpaceX thing. Check this out right here.

S3: Guys, I did want to come back to what’s going to be the largest IPO in history. We’re in our countdown phase at this point from the IPO of SpaceX, a couple of weeks away, most likely.

We’re talking anywhere from $1.5 to $1.75 to $2 trillion. You’re going to have an enormous amount of demand from index buying very soon after or not long after.

PW: There you go right there. So, now they’re going to be moving this money into this particular stock. The index funds, why? Typically, you will never see an IPO, an initial public offering, or a company that is raising capital for operations.

Most of the time when you buy stock, you’re buying it from some other schmo that owns it. That’s the way the stock market typically works. If I want to buy Home Depot stock, I’m buying it off of somebody else that owns it.

When you’re dealing with an IPO, you’re buying that off of a private owner of it, the company maybe, and maybe the company founder in this particular case, Elon Musk, or somebody like that.

And you’re buying that stock from them. It is not being bought, or it may be used in operations for the company going forward. So, therefore, it can affect the company.

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Now here’s what’s happening here with the index: With the index, they are actually looking at adding this to the index right away. Unheard of.

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You don’t normally see that at all. So, I think that that’s super interesting, and it could be a very big negative, Jim, for the investor.

Because IPOs typically lose money, as I’ve talked about on previous shows, in the first several months that they are in operation. And now you have an index driving the price up for a thing that — and we don’t know that’s going to happen, but it’s something like two-thirds of the time to three-quarters of the time, historically, IPOs lose money in the first initial months that they’re out there.

You Can Relax About Money

JW: It’s why I love what we do and the fact that I don’t have to worry about that. I really don’t.

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If it gets added to our portfolio, it will get added in the appropriate amount based on all the academics and just the area of the market that that’s in. 

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The funds that we have will add it in the appropriate amount.

PW: And they typically wait quite a while.

JW: Yeah. And so, I’m not worried about that.

PW: You can relax about money.

JW: We should use that.

PW: Somebody said that to me. A client had said that to me earlier today. I ran into him, and he was talking about his financial situation.

He goes, “But you know what? I’m not worried about it. I’m relaxed about money.” I was like, “I think I may use that.”

JW: Yeah, there you go. Yeah.

When I’m explaining the reconstitution effect, one of the visuals I like to use is that when you’re trading, because you see kind of stocks, the daily trading, it just goes up and down a little bit. Some days are bigger than some of the others. But on the day that it’s added to the index, there’s a massive spike.

PW:  Right, right, right.

JW: And so, it looks like one of those heartbeat charts, you know, when you see them?

PW: Oh, sure, sure.

JW: Every time there’s a beep, you see the line jump and come back down.

PW: Yeah.

JW: That’s what it looks like on the trading and everything.

PW: Well, it’s good when you see it with a heartbeat chart, but not necessarily good when you see it with your stocks.

JW: Yeah. Well, yeah, true. You don’t want to flatline with it if it’s the thing that’s attached to you, if the electrodes are attached to you.

PW: Your investment portfolio may flatten, I know.

JW: Yeah.

Advisory services offered through Paul Winkler, Inc an SEC registered investment advisor. The opinions voiced and information provided in this material are for general informational purposes only and not intended to provide specific advice or recommendations for any individual. To determine what investments are appropriate for you, please consult with a financial advisor. PWI does not provide tax or legal advice. Please consult your tax or legal advisor regarding your particular situation.