Stock market concentration is not a new phenomenon. It comes and goes. We believe yesterday’s investment darling always risks becoming tomorrow’s dust.
Stock market concentration measures how much of the overall market capitalization is in a small number of stocks. By design, the size of the investment in each stock within the S&P 500 Index reflects the relative market capitalization of the company. If an investor invests $1,000 in the S&P 500, you own more of the companies with big market values and less of the companies with small market values.
In the decade ended in 2023, the top 10 stocks by market capitalization in the S&P 500 nearly doubled from 14 to 27 percent of the index (source: Bloomberg). This means a limited number of stocks have significantly affected the market’s total return. For example, the appreciation of the “Magnificent Seven” (Apple, Amazon, Alphabet, Microsoft, Netflix, Nvidia, Tesla) was responsible for more than one-half of the S&P 500’s gain of 26.3 percent in 2023 (source: Russell Investments).
The table below is reproduced (with the authors’ permission) from a Morgan Stanley report titled “Stock Market Concentration: How Much is Too Much?”
RiskBridge observes the following regarding the data above:
- Of the 17 names on the list, 11 held a spot in the “top 3” for more than two years.
- Since 1950, only Exxon has persisted in the Top 3 for at least four decades.
- AT&T and IBM topped the list for three decades (it is possible Microsoft may join them).
- Dot.com-favorite Cisco (ticker CSCO) made the list only once (1999).
- Artificial Intelligence-favorite Nvidia (ticker NVDA, not shown in the table) reached the top 3 in early 2024.
Hendrik Bessembinder, a professor of finance at Arizona State University, calculated that the total wealth creation for the stocks of all U.S. public companies was $55.1 trillion from 1926 to 2022. “Wealth creation” is defined as a stock generating a return greater than U.S. Treasury bills. Twelve of the market capitalization leaders in the table above also appear on Bessembinder’s list of the top 20 value creators. AT&T, Cisco, DuPont, Eastman Kodak, and Pfizer are not on Bessembinder’s top 20 value creation list.
RiskBridge believes today’s stock market concentration may be justified if the market capitalizations mirror the value creation prospects. In other words, economic profit, defined as return on invested capital (ROIC) less the weighted average cost of capital (WACC) multiplied by invested capital, is positive ([ROIC-WACC] X Invested Capital > $0).
According to Mauboussin, when concentration rose sharply in the decade ending in 2023, the top 10 stocks averaged 20% of the S&P market cap but 47% of economic profit. This suggests the current stock market concentration may be justified.
Mauboussin argues that market concentration has implications for the active vs. index investment debate. For example, when large-cap stocks do well relative to small-cap stocks, the percentage of active mutual funds that outperform the broad benchmark falls. Conversely, when small caps outperform large caps, active managers outperform at a higher rate.
There were two decades in the last seven when active investment and active managers outperformed: the 1970s (50% of mutual funds outperformed) and the 2000s (48% of mutual funds outperformed).
According to Morgan Stanley, small caps outperformed large caps during both decades, and the S&P Index returns were well below average at 5.9% (1970s) and -0.9% (2000s).
Takeaways
- When it comes to investing, there is not much new under the sun. Which “Magnificent 7” stocks will likely remain in the “Top 3” in the next 3, 5 or 10 years? Which ones will drop out? We believe the answer lies in how successfully those management teams allocate capital to generate vast economic profits.
- If RiskBridge’s forward-looking capital market assumptions (CMAs) are correct, today’s richly valued U.S. stock market will lead to below-average returns over the next several years. Our current asset allocation positioning assumes that over the next 2-3 years, U.S. stocks may return 4.5% to 5.5%, developed international stocks may return 6.5% to 7.5%, and emerging markets may return 12.0% to 14%. We believe our CMAs are directionally correct, although empirically imperfect.
- RiskBridge believes investors may benefit from allocating more capital to active managers with strong security selection and risk management skills and tactically tilting in favor of small-cap and emerging market equities.
- Businesses transition through a natural life cycle: start-up, early growth, maturity, and renewal/decline. As companies mature, their growth opportunities and capital allocation effectiveness change. Viewed through the theoretical framework of the business life cycle, the odds are against the Magnificent 7 remaining magnificent forever.
Further research is required.
DISCLOSURE:
Past performance is no guarantee of future results. Personnel of RiskBridge Advisors, LLC (“RiskBridge”) prepared the Risk Report. The views expressed herein do not constitute research, investment advice, or trade recommendations. RiskBridge may, from time to time, participate or invest in transactions with issuers of securities that participate in the markets referred to herein, perform services for or solicit business from such issuers, and/or have a position or effect transactions in the securities or derivatives thereof.
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