Sell the S&P 500. Buy this instead.

By Brett Arends

Every two weeks, all around the country, working Americans have money deducted from their paychecks and diverted into their 401(k)s. This probably includes you.

A lot of that money is then invested in just one thing: A fund that owns the S&P 500 index SPX of large U.S. companies. People typically assume this means they are spreading their money across a wide, diversified range of big company stocks. But do they realize what they are really buying?

Read: 'We're not in Kansas anymore': Why the 60/40 portfolio might be dead, and what to do now

The stock market this year has gone so crazy that today, more than a quarter of that money is going into just seven stocks: Apple (AAPL), Amazon (AMZN), Google parent Alphabet (GOOG) (GOOGL), Facebook parent Meta (META), Microsoft (MSFT), Nvidia (NVDA) and Tesla (TSLA).

How much is going into most of the other 493? Peanuts.

These seven may be fine companies. Let's assume they all are. But this is no kind of diversification. Wall Street won't say it, but this breaks every common-sense rule in the book.

To those who think this is OK because these companies are so terrific their stocks just can't fail, lend an ear to Abdulaziz Anaim. He runs a boutique global investment firm, Mayar Capital, based in London.

For his latest letter to his investors, Anaim looked at what happened to the last group of seven "these can't fail" stock-market favorites, back in 2000.

Today's big seven are known on Wall Street as the Magnificent Seven (thanks to Jim Cramer, natch). Anaim calls the earlier version the OG -- for Original Gangster -- Seven.

They were Microsoft, Cisco Systems (CSCO), Intel (INTC), Amazon, Walmart (WMT), General Electric (GE) and Qualcomm (QCOM).

They, like the Magnificent Seven today, were almost universally beloved on Wall Street. Fund managers bragged to each other on the golf course about how much of each stock they owned in their portfolios. The stocks could do no wrong. They couldn't fail. The only way was up.

You can guess the sequel. They soon drenched their investors in a sea of red ink. All the stocks plunged. From the peaks, investors were in the negative for years. Even eventual winners, like Amazon and Microsoft, took many years just to get back to even. Amazon's stock first fell by more than 90%. Someone who owned Microsoft at the start of the millennium and held on had to wait until 2014 -- no, really -- to break even.

Read: New rules mean required withdrawals from retirement accounts have become even more complex

This wasn't because the companies failed. On the contrary, their businesses and profits grew. In some cases, such as Amazon, they did so in line with hopes. But the stocks had been too expensive to start with in relation to earnings.

OK, so today's Magnificent Seven are nowhere near as crazy expensive as the OG were back then.

According to FactSet data, at current prices Alphabet is easily the cheapest, because it trades at a mere 20 times forecast earnings. Amazon trades at 40 times forecast earnings and Tesla at nearly 60 times. Contrast that with 2000, when four of the group traded at more than 50 times forecast earnings and one, Qualcomm, was in triple digits. Crazy stuff.

On the other hand, today's behemoths are so large in market value that it starts to become mathematically challenging for them to grow faster than the economy.

Scott Glasser, the chief investment officer of ClearBridge Investments, told investors at a webinar on Wednesday that the recent performance gap between the regular S&P 500 and the "equal weight" version is now the widest it's been in around 25 years.

His point: This is unsustainable, and it is likely to be reversed. Looking ahead to 2024, he says he prefers the equal-weight S&P 500 to the regular one.

Let's go further and say the regular S&P 500, which bets more of your money on the stocks that are already the most highly valued on Wall Street, never really made the most sense for investors anyway -- and least of all now. The equal-weight version, where you bet the same amount on every stock, offers far more diversification. That may come in handy if you figure the Magnificent Seven are riding for a fall.

Happily, there are a couple of low-cost exchange-traded funds that will buy equal amounts of all the stocks for you: The Invesco S&P 500 Equal Weight RSP, which charges 0.2% a year in fees, and the iShares Equal Weight USA EUSA, which owns 600 stocks and charges 0.09% in fees.

-Brett Arends

This content was created by MarketWatch, which is operated by Dow Jones & Co. MarketWatch is published independently from Dow Jones Newswires and The Wall Street Journal.

(END) Dow Jones Newswires

10-28-23 1050ET

Copyright (c) 2023 Dow Jones & Company, Inc.