Should Investors Be Concerned About the Degree of Concentration in US Equity Markets?
Yes, because rising concentration reflects rising valuations for the largest stocks, which are likely to serve as a headwind to index returns. Further, the growing market share of these companies increases the potential for rising regulatory oversight. The better news is that investors have options to navigate these headwinds, including tactical tilts toward less expensive parts of the equity market, as well as choosing skilled active managers.
The S&P 500 Index’s top ten stocks now account for around 29% of the index’s market cap, like levels seen during the tech and telecom stock melt-up in the late 1990s. This share has increased by 10 percentage points (ppts) over the past decade. While not necessarily bad in and of itself, the recent rise in concentration has not been matched by a similar rise in earnings contribution. In fact, these stocks contribute just 22% of the index’s total earnings, less than their contribution a decade ago. Certain style indexes reflect an even more lopsided disparity. For example, the top ten stocks in the S&P 500 Growth Index account for around 51% of the index’s market cap but just 29% of its earnings.
The result is elevated valuations for these large stocks. Today, the top ten MSCI US stocks trade at 39x trailing 12-month earnings, which is roughly a 25% premium to the overall index. While this premium has compressed after spiking last summer, it remains near the highest levels seen since early 2000, at the height of the “dot-com” boom.
How we got to this point is no mystery. The COVID-19 pandemic accelerated secular trends already underway like the rise of e-commerce, cloud computing, and advertising moving to the web. Investors were attracted to the healthy earnings growth generated by COVID-19 beneficiaries last year, which contrasted with the overall decline in US index earnings. Still, the price performance of many of these firms far outpaced their earnings growth and caused valuations to surge. Using one proxy, the 45% return for the US information technology sector vastly outpaced its 7% earnings growth.
The concentration of the largest stocks in or close to the technology sector poses other risks. Government scrutiny of the market dominance of these firms has been rising on both sides of the Atlantic and was poised to increase further even before recent US election results. Looking farther out, tech’s growing inroads into businesses like retailing, banking, and media may eventually be challenged as traditional incumbents adapt business models.
Investors have several options to navigate these challenges. Active managers can construct portfolios to express views on market imbalances. But investors should understand that rising market concentration has historically been associated with a wider range of active manager outcomes and higher volatility relative to benchmark index returns.
Put another way, higher concentration may mean active managers have higher risk but also higher return prospects. In fact, the spread between the best- and worst-performing US large-cap active equity managers was a whopping 48 ppts in 2020, which represents the largest divergence in the last 20 years, according to eVestment. That level was significantly higher than the 33 ppt difference in 2009, which was a period when market volatility was elevated but S&P 500 Index concentration was not stretched. While equity index concentration levels remain high, investors seeking to take advantage of lopsided valuations within market cap–weighted indexes should recognize that both outperformance and underperformance relative to benchmarks may be elevated compared to that experienced over the last couple decades.
Another option is for investors to lean into less expensive areas of the market, such as Asia ex Japan, global ex US, small-cap, and value equities. These indexes performed well in fourth quarter as a rebound in economic growth, fueled by rising vaccinations and easing restrictions, helped 2021 earnings expectations surge. While we are watching valuations closely (given, for example, US small caps have returned 35% during the last three months), these markets remain attractively valued relative to broad US equity markets.
The bottom line is that rising index concentration creates challenges for investing in US large-cap equities. While a renewed COVID-19 outbreak could see investors further increase exposure to perceived mega-cap winners from recent trends, eventually the stretched valuations of these stocks are likely to weigh on relative returns. To manage this risk, investors should look to skilled active managers and consider thoughtful positions in more reasonably priced markets.