Stocks keep getting whipsawed.

That much is evident with yesterday’s 570-point plunge in the Dow Jones Industrial Average.

And when you flip to the news to find out what’s going on, you hear about political brinksmanship involving spending bills, the debt ceiling and prospects of a federal government shutdown … among other things.

But none of those are the real driver of yesterday’s volatility.

The real driver was interest rates. Surging Treasury yields sparked a massive rotation that dragged stocks lower.

Now, if you’re an investor that uses exchange-traded funds (ETFs) tied to an index like the S&P 500, you’ve undoubtedly been conditioned to buy the dip.

But before you do that this time, know this: Rising interest rates could lead to a risky new phase in the stock market.

It’s one that will look nothing like the past decade … and will curtail recent stellar returns going forward … especially for buy-and-hold index investors.

Here’s why and how rising interest rates come into play…

Understand the Risks

Ever since the great financial crisis, investing in broad market ETFs was a sure path to profits. The SPDR S&P 500 ETF Trust (NYSE: SPY) that tracks the S&P 500 has delivered cumulative returns of 726% since the lows in 2009.

But SPY is becoming a victim of its own success. The stocks that have driven the market to new heights now make up a huge portion of the index.

You may think that you’re diversified across 500 stocks, but the top 10 members now make up nearly 30% of the index. That’s almost double the concentration compared to just five years ago. It’s now higher than during the dot-com bubble … as you can see for yourself below:

Source: J.P. Morgan Asset Management

(Click here to view larger image.)

Here’s another thing. Those top 10 holdings sport a price-to-earnings ratio that is 50% higher than all the remaining stocks in the S&P 500!

The thing is, expensive stocks are most sensitive to rising interest rates. Because they dominate broad market ETFs, any movement in interest rates has a knock-on effect.

That’s why index investing is becoming a dangerous game. Those same growth stocks that pulled the index ETFs higher can drag them lower as well.

That doesn’t mean you have to run away from stocks. As Ted explained yesterday, there are still opportunities. But to find and take advantage of them, you need to change your investment strategy.

Don’t Become a Victim!

Some stocks — particularly those big names driving the S&P 500 — wither when faced with surging yields. But there are other stocks that thrive.

Rising interest rates signal economic growth and inflation ahead. So cyclical areas of the stock market do well … such as industrials or small-cap value stocks.

But here’s the thing…

The ones that thrive aren’t well represented in broad market ETFs. For example, the SPY ETF will only get you a modest allocation to industrials and zero exposure to small caps.

So, if you rely heavily on index investing, you’re going to miss out on these opportunities.

The good news is there’s an easier way. At The Bauman Letter, we structure our model portfolio of recommendations so that you have multiple investment types to evaluate … including deep value and income opportunities.

So, stay smart, stay tough and don’t become a victim of the S&P 500’s success!

And think about the best opportunities before you buy THIS dip!

Best regards,

Clint Lee
Research Analyst, The Bauman Letter