NASDAQ’s upcoming rebalancing, announced on July 7, has piqued the interest of many investors, given its potential impact on a broad array of stocks. The NASDAQ 100 has witnessed a record-breaking start this year, amassing gains of over 40% through June, marking its best performance in four decades. This noteworthy surge, extending into July, follows last year’s bear market that saw investors retreat.

Key to this impressive rally has been the powerhouse collection of technology-focused large-cap stocks known as the “magnificent seven.” This includes industry giants like Meta Platforms, Apple, Amazon, Alphabet, Microsoft, Nvidia, and Tesla. Their stocks have rallied as investors, eager to reenter the market, have shown a preference for the relative safety of large corporations. The stocks have also been buoyed by the surging spending on artificial intelligence and the weakening U.S. dollar.

However, the stellar performance of these tech behemoths has not been without its complications. Microsoft and Apple have seen their stocks rise by 61% and 53% since last fall, while the likes of Meta Platforms and Tesla have doubled their worth on the back of optimism surrounding ad spending and electric vehicle demand. These robust gains have resulted in these seven stocks accounting for a disproportionately large weighting in major stock market indexes. For instance, Microsoft and Apple alone make up approximately 25% of the NASDAQ 100, while the top 10 holdings account for nearly 60% of the index. This means these dominant players wield a more significant influence on the index than investors may be aware of.

To address this concentration issue, NASDAQ has announced a special rebalancing set to take place on July 24. This move, intended to normalize weightings, will affect the heavyweight stocks and influence the trajectory of smaller stocks within the NASDAQ 100.

The weighting imbalance in the NASDAQ 100 largely stems from a rally driven by large-cap technology stocks. Investors, typically cautious during a bear market, have flocked to these stocks due to their perceived safety and liquidity. Historically, technology has been a leading sector in early market cycles, and these tendencies have played out with this rally. However, this has resulted in the NASDAQ 100 becoming excessively concentrated around the ‘magnificent seven’, countering its mission of reflecting a broad spectrum of growth-oriented stocks.

To curb such concentration risks, NASDAQ has established rules which allow for a special rebalance when weightings lean too heavily towards the largest holdings. Yet, special rebalances are rare, the last one occurred over a decade ago. As a result of this rebalancing, it is expected that the five largest stocks will see a reduction in their weightings, with the redistributed weight likely favoring the smaller stocks.

The NASDAQ 100 operates as a “modified market cap-weighted index,” meaning that it has certain restrictions impacting the weights, including caps on the maximum and minimum weights for individual stocks and categories, such as by sector or country.

The upcoming rebalancing provides a potential opportunity for short-term gains, with possible buying and selling ahead of the official rebalancing date. Stocks are already beginning to reflect the anticipated changes. However, these changes may be short-lived as the market swiftly adjusts, and once these changes are reflected, stocks typically revert to their previous trend. 

While active traders might be keen to capitalize on these shifts, most investors are advised to stick to their established strategies, as the short-term gains may not be worth the risk of owning an unwanted stock.

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