- The bearish case is a quantitative one
- So how about the bullish case?
- What does one do?
I’ve discussed the impact of the “Great Eight” (Apple, Microsoft, Alphabet, Amazon, Nvidia, Tesla, Meta, and Netflix) a few times before in this blog. But today I want to delve into my evolving and nuanced view on how investors should think about a U.S. equity market that is arguably more concentrated than ever before. So here’s how I’ll approach this – with the bearish argument, the bullish one, and then some views on practical implementation.
The bearish case is a quantitative one.
These eight stocks simply represent too much concentration in a U.S. equity sleeve. At the time of writing they account for somewhere around 30% of the market cap of the entire S&P 500. As the chart below shows, that’s not far off the highest concentration we have ever seen. But here’s a really key point that differentiates today’s concentration from some of the previous episodes – the Great Eight are pretty much all in, or heavily involved in, the technology and digital sectors. So, it’s not just a question of concentration, it’s also, critically, a question of correlation too. Not only are these companies influential and dominant, but they are broadly active in the same fields, that makes this concentration even riskier. For example, think about their European equivalents, the eleven “Granolas” (GSK, Roche, ASML, Nestle, Novartis, Novo Nordisk, L’Oreal, LVMH, AstraZeneca, SAP, and Sanofi). At least here there is representation from the pharmaceuticals, semiconductors, food & beverage, cosmetics, luxury goods, and healthcare sectors, as well as, yes, the tech sector. But it’s a very different type of concentration risk to the Great Eight – this is a concern.
So how about the bullish case?
Well, the fact remains that the Great Eight still have the most impressive sales and earnings growth in the market, and, consequently, they have been the real engines of investment returns. To the old saw, “you shouldn’t keep all your eggs in one basket,” the rejoinder is “but these are golden eggs!” They are driving and still dominating S&P 500 earnings growth, both now and in consensus forecasts. So, in addition to a very concentrated market, I’m also still pointing out a “bifurcated” market. We have extraordinary earnings growth at the Great Eight, but very low and still below normal growth at the other 492.
Now, if those are the two cases, what does one do?
Well, I believe that diversification still has value, even if it comes at the cost of some return. I am not saying that trying to diversify this concentration will ultimately produce a higher return, but I think reducing risk is valuable especially when risks are hard to identify and quantify in advance in the dynamic digital world, thus I think we need to look for some alternatives to what has essentially become tech dominating the titans of the S&P 500. What are some of those alternatives? The equal weight S&P 500 would be one obvious thought, but I think that can be improved upon. I am not as worried about a U.S. recession as I was, but if it were to happen, I would expect it would disproportionately hit the smaller stocks, and so the equal weight would leave one exposed to a downturn. I’d probably be more tempted by an equal weight growth index strategy, as I don’t think we’re quite at the point yet where an overweight to value makes sense.
Two final thoughts.
Firstly, I often get the question of “how long can leadership and dominance like this continue?” Think back to the Nifty Fifty and even the more recent dot com rally from around 1995-2000, and, the fact is, the “growth over value” trade and the ”big cap tech over all else” trade have pretty much been in place since the Financial Crisis, and held up, and further thrived through the pandemic. Thus, this dominance by a sector and a concentrated group of the largest S&P 500 stocks has had an incredibly long run, but new leadership hasn’t emerged.
Finally, consider this. Who gets hurt more if interest rates remain high? In theory the Great Eight are effectively a higher duration asset class (i.e., more sensitive to interest rates in a discounted cashflow (DCF) context, with higher rates worse for them), but, if you look at the recent evidence, when we have lived with these higher rates, it’s the 492 that have come under more pressure. Provided long-term yields don’t surge, we think the Great Eight delivering the roughly 20% earnings growth expected from them through 2025 is what matters more. Even for these great companies, some bumps are likely along the way.
My final take away – It is, as I said, a nuanced and subtle story. It needs a thoughtful and tailored approach. Come on, surely you prefer that, it’s ultimately what keeps it all so interesting!
Good luck,
– David
Largest companies % of S&P 500 market cap
Source: Clarifi, as of 4/30/2024
