What On Earth Is The NASDAQ “Special Rebalance” And What Are The Implications?!
Over the last three months we have spent quite a bit of time covering the fact that the rise in the US stock market has been very narrow.
You can find some of our earlier work here and here.
By narrow we mean that only a handful of stocks have been responsible for the lion share of the market's gains.
In fact, of the hundreds of large publicly traded companies, only really 5-10 have been responsible for 80-to-100%+ of the very healthy market returns this year.
(the reason it can be more than 100% at certain times is because they whole rest of the index has been DOWN for the year)
The question has of course been, will the rally continue or will it run out of steam?
It was a big question and one we have focused on a few times recently. Our argument was essentially that the rally would have to either to broaden or be vulnerable to a very sharp and sudden correction. Either more companies will start to partake in the rising ride or it will peter out and probably reverse.
Well, early on Tuesday of this past week we woke up to a message from a loyal Pebble user (and reader!) asking about the "Special Rebalance of the NASDAQ" and what did it mean?
We will be honest here, our first reaction was two separate thoughts:
Wait, what special rebalance of the NASDAQ?!
And second, INTERESTING!
After some furious digging we realized that the Nasdaq corporation had decided that they had a unique solution to the problem of an increasingly narrow market dominated by only a handful of the largest tech companies.
They would simply rebalance the index.
By that they mean they will change the weightings in their NASDAQ-100 index to give the super large mega cap technology companies like Apple, Microsoft, Nvidia etc less of a significant portion of their index of the top 100 technology companies.
In true 21st century fashion, we would rather have an index that looks correct rather than works correctly.
Nasdaq cited the fact that 6 companies combined now make up nearly 50% of the index which contravenes some of Nasdaq's own regulations around fund diversification. The top 3 (Apple, Microsoft and Nvidia) companies are now over 30%.
In other words, when you buy the NASDAQ-100 you are increasingly just buying 6 companies. It is undoubtably true that that isn't much of an index!
In case you have forgotten the Super 7 Theme we have covered before and can be found right here:
As you can see they are still doing exceptionally well and nothing has really changed since we first wrote about this topic.
Here is their performance this year:
You have to give it to the good folks at Nasdaq (a publicly traded company itself trading under $NDAQ), this was an innovative solution to the "this is a narrow rally" problem.
Rather than continue to watch the index get further dominated by a few stocks, Nasdaq instead decided that they will be changing how they calculate the underlying index that investors purchase.
Problem solved!
Now this isn't new. Nasdaq, as a purveyor of indices, has long had a provision that when any group of big stocks (defined as being each individually above 4.5% of the index) amounts to more than 48% of the index, then the index will must rebalanced.
The companies in question undoubtably meet the criteria. Further, the indexing firm can do this any time.
As their own methodology clearly states:
"....a special rebalance may be conducted at any time…if it is determined to be necessary to maintain the integrity of the index."
Understandably, this announcement caused all manner of excitement and also led to - temporarily - these biggest companies selling off to the tune of 1-2% on the day itself.
But after we got over our shock, we immediately thought:
Wait. Hold on. How is this going to work exactly?
If you have a $3 trillion dollar company on Monday and you tell everyone you are going to rejigger the math so every dollar invested is now only a fraction of that won't that simply encourage more people to buy the stock of that company?
Apple was already overvalued by every conceivable metric at the start of the week and why would changing the index weight make it fundamentally any less popular?
We are genuinely unsure.
Nothing has actually changed to the future expected prospects of Apple or Nvidia. This is just changing the underlying math of the index. It does nothing to the actual companies or their profits or the reasons that millions of people and computer programs are buying their shares in the first place.
Some obvious takeaways:
Indexing matters! As we always say, what you own and how you own it matters. Owning the NASDAQ 100 would mean outperforming the S&P 500 by over 20% this year, which is simply a stunning difference. Further, owning an ETF or index that DOESN't do this rebalance could deliver very different results going forward.
Second, redefining and rebalancing the index is all fine and well but that really just masks the underlying problem.. It does little to really address the tricky issue confronting both the market and the country tiself - we have an unbalanced stock market and perhaps also a broader economy.
Third, this is wild? No doubt Nasdaq has the right to alter the NASDAQ-100 in whatever way they wish but there are hundreds if not hundreds of thousands of products and strategies based on this index so changing it is a very major deal.
For one thing the famous Invesco QQQ ETF which tracks the NASDAQ-100 and has well over $200 billion-with-a-capital-B in it is going to have to very quickly shift billions and billions of their holdings around to make sure they are tracking the underlying index properly.
That means that the second most widely traded ETF (after SPY which tracks the S&P 500) is going to be undergoing some serious internal upheaval in the coming weeks.
Meanwhile other ETFs, such as Cathie Wood's ARKK ETF that have largely missed out on this rise of the biggest of the big tech companies will gain as the NASDAQ forces passive investors to rebalance into their holdings.
Talk about crashing your car into a gold mine....
Put this all together and it suggests that a lot of mandatory trading and therefore a lot of volatility is heading our way between now and the end of the month. Further, because of this other investors are going to try and "front run" or trade ahead of those expected changes which will only accelerate the trend.
Anyway, the details will be released on the 14th and the rebalance will happen on the 24th. As an indexing company we find this all pretty fascinating and very useful for underlying that, well, indexing is pretty important and the only way to make sure that your underlying index doesn't change is to actually control it yourself.
And that is actually exactly what we do here at Pebble. Not sort of. Exactly what we do. When you build an index or portfolio on Pebble (your own "Pebble") it stays yours. There are zero "special rebalances" in our methodology documents and we will most certainly not spring one on you without making it very clear ahead of time.
So, if you don't like this from Nasdaq, you might enjoy the experience at Pebble. Whether your index is narrow or broad, up or down, at the very least you will be in charge.
But away from our own narrow point of view this is also quite something. Prior to this financial wizardry, six individual companies now dominate half of one of the largest and most important indices.
This is both unusual and something to take note of and prepare for more unexpected behavior to occur. Wouldn't it be ironic if very quickly this special rebalance was made unnecessary because of either falling markets or a broader rally?
The Nasdaq special rebalance isn't the only chaos at present either....
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