Index concentration matters and rising concentration in the S&P has raised concerns over market bubbles, spurring comparisons to the tech bubble. And similar to 1999, right now the largest market cap stocks are technology stocks, which also happen to be where investors and markets are most focused. In our view while the majority of the S&P 500’s concentration is largely in technology stocks, we think comparisons to 1999 are misplaced, especially given the “post-COVID world” and dynamic changes occurring across industries and companies.
S&P 500 Historic Constituent Concentration
S&P 500 concentration has oscillated over the past 20 years, but on average the top 10 stocks have comprised ~22% of the index since 1995. Following the financial crisis in 2008/2009 the concentration of the index steeply dropped and had hovered near 20%. However since 2014 concentration of the S&P 500 has steadily increased, largely driven by the prolonged market rally and sentiment toward technology companies. Today the 10 largest names (out of the index’s 500 total) represent just under 30% of the index, the highest concentration the index has ever experienced.
Media and analysts have covered this topic ad-nauseum, especially this year as the market has rebounded from its COVID-19 low. Analysts make the point that the index is no longer truly diversified, and that with so few companies driving the performance of the benchmark, a shift in consumer sentiment could be devastating. While these are valid arguments, we think this scenario of “drastic consumer sentiment change” is less likely in the current environment given:
- Flows into passive investments don’t discriminate based on valuation, or even sectors. As long as investors continue to have a long-term “risk-on” (e.g. invest in equities) mentality, this passive capital is likely to remain permanent, providing support to index concentration.
- In our view, fundamentally technology companies appear better positioned right now for a post-COVID world than competitors. Whereas financial, healthcare, and other industries rely on speed, fast access to data, person to person contact, etc. for their operating and competitive edges, technology companies are less reliant on these needs; technology company competitive edges do not come from speed of data access, which should allowing for increased ability to remote work.
- With sports still limited, aggressive participation from retail investors is likely to persist, providing additional support levels to many of these names.
S&P 500 Valuation Is High, But Not Concerning (yet)
Further adding to this discussion are concerns over market valuation, which continue to rise from their COVID-19 lows. We won’t argue that current valuations may be valuing companies to perfection, but valuations are still well below the peak levels experienced during the technology boom and “day trading” fever of the late-90s.
With the valuation gap between LTM and NTM earnings near its lowest level in history, it suggests that either analyst earnings estimates need to be revised significantly higher, or a true downturn is headed. In our view analyst knee-jerk estimate reductions over compensated from the impact of the COVID-shutdown, and should start to stabilize as 2Q earnings season progresses.
Nothing beats diversification
We remain optimistic in our outlook for the the US economy and market, but caution investors to remain disciplined and avoid overly concentrating their portfolios. For long-term investors a diversified portfolio remains essential.
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A word on risk
All investments carry a certain degree of risk, including possible loss of principal, and there is no assurance that an investment will provide positive performance over any period of time. Equity investments are subject to market risk or the risk that stocks will decline in response to such factors as adverse company news or industry developments or a general economic decline. Debt or fixed income securities are subject to market risk, credit risk, interest rate risk, call risk, tax risk, political and economic risk, and income risk. As interest rates rise, bond prices fall. Non-U.S. investments involve risks such as currency fluctuation, political and economic instability, lack of liquidity and differing legal and accounting standards. These risks are magnified in emerging markets. This report should not be regarded by the recipients as a substitute for the exercise of their own judgment. It is important to review your investment objectives, risk tolerance and liquidity needs before choosing an investment style or manager.