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Is the Recent Concentration of US Equity Performance in a Small Number of Stocks a Cause for Concern?

Cambridge Associates

Michael Salerno

Answers to our clients’ questions about market action and the market environment in a few paragraphs every two weeks.

Not in our opinion. Recent market leadership by the so-called FAAMG stocks is not extraordinary relative to history, and their valuations and fundamentals, combined with this year’s relatively healthy market breadth, mean that they don’t necessarily present an outsized threat at this time.

The strong year-to-date outperformance of a handful of mega-cap technology or technology-related stocks featuring prominently in the S&P 500 Index has led some market pundits to suggest that such concentrated performance indicates heightened risks of a market correction. Index heavyweights Apple, Alphabet (Google), Microsoft, Facebook, and Amazon (collectively, “FAAMG”) have helped power the US equity market to new all-time highs in 2017. These stocks are now the five largest constituents in the S&P 500, accounting for 12.7% of the total index market cap on a combined basis.* They were also the five largest contributors to the S&P 500’s 10.3% year-to-date price return through July 31, accounting for roughly 29% of the market’s overall advance.

Though the year-to-date contribution of these five stocks is above average relative to calendar years since 1991 during which the S&P 500 price index has appreciated, various measures of US equity market breadth suggest it remains relatively healthy. The ratio of stocks advancing to stocks declining so far in 2017 is roughly 2.5 to 1, the highest since 2014. Advancers well outnumbered decliners again in July, with nearly two-thirds of S&P 500 constituents notching gains. In addition, the S&P 500 cumulative advance-decline line has closely tracked the S&P 500 price index since the start of the year. The lack of divergence between the two time series in recent weeks suggests that market breadth remains relatively healthy even as the market climbed to multiple all-time highs last month. The market was also able to overcome brief wobbles by technology stocks in both mid-June and late July.

Although the market’s recent performance has not been overly concentrated, the composition of the market is more concentrated today than usual, particularly given that the top five S&P 500 constituents are all technology-related names. However, the market’s current concentration levels remain well below their bubble-era peaks. The S&P 500 Index’s current level of concentration within the top constituents is slightly above average based on data back to 1990, but the combined weights in the top five (12.7%) and top ten (20.3%) stocks today remain well below the March 2000 technology bubble highs of 18.1% and 26.6%, respectively. The IT sector is also more concentrated than usual but, again, not as top-heavy as at the height of the bubble. Furthermore, the index’s current exposure to the IT sector (23.8%), though well above the post-1989 average, has not begun to approach its 32.6% peak in August 2000. (Note that the IT sector does not include Amazon as it is classified as a consumer discretionary stock.)

In terms of fundamentals and valuations, data show that the FAAMG stocks contribute a meaningful portion of the S&P 500’s earnings and sales, arguably justifying their above average valuations. According to Goldman Sachs, FAAMG’s share of the 2016 earnings and sales for the S&P 500 was 10% and 6%, respectively. A similar analysis by J.P. Morgan showed that these five stocks account for approximately 17% and 12% of the S&P 500’s estimated revenue growth and earnings growth, respectively, for the forward 12-month period. J.P. Morgan also estimated forward price-to-sales and price-to-earnings ratios (excluding cash) of 3.4x and 19.2x, respectively, for FAAMG in June 2017, compared to 21.2x and 72.0x for a group of the largest five stocks (Microsoft, Cisco, Intel, Oracle, and AOL Time Warner) at the dot-com bubble’s peak in March 2000. The Goldman Sachs analysis also compared fundamentals and valuations of the FAAMG stocks with those of a slightly different group of dot-com stars (Microsoft, Cisco, Intel, Oracle, and Lucent). Their analysis showed that the FAAMG stocks look far more attractive on valuation, balance sheet health, and free cash flow generation. And though the FAAMG stocks appear weaker than the dot-com darlings on profitability metrics, this is arguably due to the higher reliance of FAAMG stocks on capital investment and their practice of more accelerated depreciation. Their profitability remains much higher than the broader market.

Despite the strong year-to-date outperformance of the IT sector and the FAAMG stocks specifically, their contribution to the S&P 500’s performance is not extraordinary. Any time the largest constituents outperform the broader market, they are going to be large contributors to overall index performance. That the top five constituents in the index are all effectively in the same sector speaks to their sustained outperformance this cycle, and even though the levels of concentration in both the overall index and in the IT sector are above average, both were far more concentrated during the tech bubble. Valuations for the FAAMG stocks, though elevated relative to the broader market, appear to be still far from bubble levels, and arguably reflect fundamentals that are much stronger than those of the dot-com darlings at the peak of the bubble.

* Alphabet’s shares are split into two classes; the company is second largest when the weights of both share classes are combined.

Originally published on August 15, 2017

Michael Salerno is a Senior Investment Director on Cambridge Associates’ Global Investment Research team.

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