Investors in the S&P 500 Index who think they are getting exposure to a diversified basket of 500 companies are not. Money deployed into the S&P 500 is increasingly a wager on the health of just a few companies – with the fundamental of the other 490 carrying less weight.

The outperformance of the largest stocks has lifted US equity market concentration to the highest level in decades. The concentration of both market cap and earnings in the largest stocks has risen during the past decade and accelerated with the strength of the mega-cap tech stocks during the past year. The 10 largest stocks now account for over 37% of S&P 500 market cap, the highest in over fifty years (1).

When a small subset of companies makes up a large portion of a portfolio, for better or worse, their returns will have a more significant impact on overall portfolio results. So far, it has helped drive a stretch of solid US equity market returns. The S&P 500 has generated an annualized total return of 16% during the past five years, compared with a 30-year annual average of 10%. Even including the 36% decline in 2022, an investor who only owned the 10 largest S&P 500 stocks in each of the last five years would have enjoyed a compound annualized return of 20%.

The strong performance has led to further concentration, reducing the benefits of diversification. Technology is over 30% of the S&P 500 Index. Technology doesn’t include Amazon, Tesla (discretionary), Meta, or Google (communications). If you include Amazon, Tesla, Meta, and Google as technology companies, tech would be over 44% of the S&P 500 (2). Using Morningstar-style box data, the S&P 500 should be considered a large growth fund. Before this year, it had always been classified as a large blend fund.

The concentration could increase a portfolio’s exposure to idiosyncratic risks. One sample of common risks across the largest companies includes reliance on the general availability of semiconductors, most of them having considerable investments in AI, four of them having ties to Foxconn, and their average revenue exposure to China and Taiwan being close to 20%. A geopolitical event that hurts U.S. companies’ access to China, Taiwan, and the semiconductor industry is a large risk.

While the degree of market cap concentration today is higher than the peaks reached in 1973 or 2000, the largest stocks today are much different than in the past. Today’s largest stocks are high-quality businesses that have successfully monopolized many sub-industries. This has given them high earnings and revenue growth, high profit margins, and strong balance sheets (3).

Today’s market concentration is also not driven by the same speculative nature as other recent bubbles, stretching back to the Nifty 50 era of the early 1970s, the Japanese bubble in the late 1980s, and the technology bubble in 2000 (4).

This doesn’t mean the top 10 stocks are cheap. They trade at higher multiples than the remaining 490 stocks in the S&P 500 and substantially higher than non-US markets and small and mid-cap indices (5). Historical evidence shows that higher valuations typically lead to lower future returns. (7)

Not only that, but data show that strong returns of dominant companies fade over time. Since 1957, the 10 largest stocks in the S&P 500 have underperformed an equal-weighted index of the remaining 490 stocks by 2.4% per year. However, there have been two periods where the largest 10 stocks outperformed by a wide margin – the first being the six-year run-up ending at the top of the internet bubble, and the second being the current run-up that began in late 2015 where the largest 10 have outperformed by 4.9% per year on average (6).

A few graphs to gain perspective on the degree of concentration.

The market cap of the Mag 7 is the same as the combined market cap of the entire stock markets in the UK, Canada, and Japan combined.

The Mag 7’s market cap is larger than the combined S&P 500 Energy, Materials, Industrials, and Financial sectors.

S&P 500 sector weights have shifted significantly over time…

And are not always correlated with the proportionate contribution to net income. For example, tech is 30% of the S&P 500 but only accounts for 20% of the S&P 500’s net income.

In light of this concentration, we think it is more important than ever to remain diligent on diversification in our equity allocations. Any tilts away from large-cap growth can help increase diversification. Please contact your advisor with any questions.

Footnotes:

1. Table data from Morningstar, as of 7/1/2024. Graph from Ned Davis Research as of 7/5/2024.
2. As of 7/1/2024
3. Goldman Sachs Global Investment Research, as of 3/11/2024
4. Goldman Sachs Global Investment Research, as of 3/11/2024
5. Goldman Sachs Global Investment Research, as of 3/11/2024
6. GMO, data from 1957-2023
7. SJivraj, Farouk, and Robert J Shiller. “The many colours of CAPE.” (2017).

INDEX DEFINITIONS

The Standard & Poor’s 500 Index is a capitalization-weighted index of 500 stocks designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries. It cannot be invested into directly.

The Russell 2000 Index is an unmanaged index generally representative of the 2,000 smallest companies in the Russell Index, which represents approximately 10% of the total market capitalization of the Russell 3000 Index.