It was a rough start to the year for a group of stocks affectionately dubbed the Magnificent 7.

The Bloomberg Magnificent 7 Index, comprised of mega caps including Apple, Microsoft, Alphabet, Amazon, Meta, NVIDIA, and Tesla, fell 3.0% last week. That underperformed the S&P 500’s return of -1.5%.

Does that portend trouble ahead for the rest of 2024? No one knows for sure, but if recent years are any indication the answer could be yes. As shown below, the Mag 7 started off weak in 2022 and finished the year down 45%, which significantly lagged the broader S&P 500’s return of -18% and the Dow Jones Industrial Average’s -7% return. Not so magnificent.

In 2023, the opposite pattern emerged. The Mag 7 bottomed at the beginning of the year and subsequently surged 107%, trouncing the S&P 500 (+26%) and the Dow (+16%).

 

 

The Mag 7 are lauded for their strong fundamentals. Indeed, these companies boast some of the strongest balance sheets and monopolistic traits the world has ever seen. But they are not driven by fundamentals alone. Flows also matter. Specifically, passive flows.

This is because the passive share of the US equity market has steadily risen from 35% in 2012 to 60% today.

 

 

As more people pour capital into passive vehicles that track popular market-cap weighted benchmarks like the S&P 500 and NASDAQ, this disproportionately benefits the largest companies.

For example, Google was fined $700 million last month to settle antitrust complaints brought by the attorneys general from three dozen states. It seems like a lot of money, so one could easily surmise why news like that might put a dent in the stock price. But it didn’t. The day of the announcement (December 19) the stock finished up.

One thing that may help explain that is the SPDR S&P 500 ETF (SPY) raked in a record single day inflow of $20.8 billion that same day. Given that Google’s parent company, Alphabet, represents about 3.7% of the S&P 500 index, that passive inflow benefited Google to the tune of about $770 million.

In other words, one day of passive inflows outmatched the entire antitrust fine.

If regulators are serious about punishing monopolistic behavior, maybe they should look at how these monopolies are funded? If passive share keeps climbing, so will the valuations and financial resources of these corporate goliaths we call the Magnificent 7.

However, passive flows can go the other way, too. In a year like 2023—when a bunch of money moved off the sidelines into the equity market—the biggest passive beneficiaries surged by triple digits.

But the year prior was a different story. In 2022, inflation caused financial conditions to tighten considerably, which led to staggering losses for companies like Tesla (-65%), Meta (-64%), and NVIDIA (-50%).

If 2024 turns out to be another tough year, flows may turn south again, and the most widely owned names like the Mag 7 may struggle again. I don’t know if that will happen, so please don’t interpret it as a forecast. Just consider it a warning. Flows matter a lot more in the modern market that’s becoming increasingly dominated by passive funds. One way to hedge that flow dynamic is to make sure you also have a strong fundamental bent to your portfolio.

The Dobermans of the Dow

Six years ago, I introduced Forbes readers to a stock strategy called the Dobermans of the Dow. I’ve been doing annual updates ever since. Due to regulatory changes that limit my ability to publish backtest data going forward, this will be my final one.

The idea for the Dobermans of the Dow originated on a golf course. I was playing with a young man who had just started to dabble in the stock market. When I asked what his process for selecting stocks was, he cited message boards and CNBC. Then I asked what fundamentals he looked at. It quickly became apparent that things like income statements, balance sheets, and valuations played no role in his process. He was trading mostly based on his personal intuition.

I thought he could benefit from a fundamental strategy to diversify and complement his trading strategy, so I told him about the Dogs of the Dow. The strategy simply buys the ten highest dividend yielding stocks in the Dow at the beginning of every year. Since dividend yield is the only criteria, it’s a relatively easy strategy for individual investors to implement.

Then he asked an astute question: “Do you run that strategy?”

I told him I did not. The reason is because even though I think dividends are an important variable to consider, I prefer to assess stocks using a multi-factor process. I explained how at my RIA firm we rate stocks based on a ten-factor model that is comprised of five quality factors and five value factors. In my view, weighing quality against price is the most common sense way to shop for anything, including common stocks.

For example, I wouldn’t buy the best broom in the world if someone was going to charge me a million dollars for it. No matter how good it is, it’s just not worth it.

Conversely, I wouldn’t automatically buy the cheapest broom in the world, either. What if it was damaged and destined to fall apart the first time I used it? No matter how cheap it is, it’s just not worth it.

In the investing world, a high-quality asset is one whose intrinsic worth reliably grows at an attractive rate. Over the long-term, quality assets generate quality investment returns. If you buy quality assets when they are temporarily marked down and cheap, you do even better.

Then, the young man asked another astute question: “How have the Dogs of the Dow performed over time?”

I told him I didn’t know, but figured the performance must be pretty good since the strategy has been popular for several decades.

After I returned from the golf course that day, I booted up my Bloomberg and backtested the Dogs of the Dow. The long-term results were decent, but not earth shattering. So, I invented a stock screen that better embodied my Quality at a Discount philosophy.

1. Rank the thirty Dow stocks by Return on Equity, keep the top twenty.

2. Rank the remaining names by Free Cash Flow Yield, keep the top ten.

Those final ten stocks are what I call the Dobermans of the Dow.

Historically, a hypothetical Dobermans of the Dow portfolio has performed relatively well. But the screen has underperformed the Dow for several years in a row, and I think the passive trend that has favored the Magnificent 7 in recent years likely plays a role in this. I explained that thesis in more detail in my 2022 Dobermans update.

Hedging the Passive Bubble 

Someday, this passive bubble we’re living in will burst. It has too. Even John Bogle, the godfather of the passive movement, acknowledged there were limits to passive investing.

In 2017, Bogle said: “If everybody indexed, the only word you could use is chaos, catastrophe... The markets would fail.”

As mentioned earlier, about 60 percent of US equity funds are now invested in passive products. Between here and 100 percent, when exactly should we worry? Where is the tipping point? And who is monitoring that on behalf of the millions of investors who routinely park their retirement savings in passive products ? Surely not Vanguard.

I don’t know when the passive bubble will burst, but I advise you to look out for you. Regulators are notoriously behind the curve when it comes to stock market bubbles, and this episode will probably be no different.

The point here isn’t to imply you should sell all passive investments immediately. Like the young man I met on the golf course that day, I simply encourage folks to diversify at least part of their portfolio into a fundamental strategy. The Dobermans of the Dow is one option to consider.

In my first Dobermans of the Dow article, I told the story of Karl Friedrich Louis Dobermann. He was a tax collector and dog catcher who lived in Germany during the 1800s. He invented the Doberman breed to help protect himself from thieves while he was making his rounds.

The Dobermans can help protect your portfolio when the mother of all mean reversion trades arrives, and that will be when the passive share of the market starts receding. I think that will be an era when fundamental strategies thrive.

If you want to continue to track the Dobermans list annually, there are free stock screeners available online that can help you do that.

My firm, Silverlight Asset Management, also runs a separate account version of the strategy that incorporates both fundamental and flow signals. That strategy presently has a two-year track record of beating the Dow, and delivering a cumulative net return of 16.3% vs. 8.2% for the index.

Best of luck in 2024!

 

* Originally published by Forbes. Reprinted with permission. 

---

Disclosure: This material is not intended to be relied upon as a forecast, research or investment advice. The opinions expressed are as of the date indicated and may change as subsequent conditions vary. The information and opinions contained in this post are derived from proprietary and non-proprietary sources deemed by Silverlight Asset Management LLC to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. As such, no warranty of accuracy or reliability is given and no responsibility arising in any other way for errors and omissions (including responsibility to any person by reason of negligence) is accepted by Silverlight Asset Management LLC, its officers, employees or agents. This post may contain “forward-looking” information that is not purely historical in nature. Such information may include, among other things, projections and forecasts. There is no guarantee that any of these views will come to pass. Reliance upon information in this post is at the sole discretion of the reader.​​