Is the S&P 500 Too Concentrated? (EP.146)

0:28We all need to make smart decisions with our money. We're zooming in on the Magnificent Seven, which, if you're not familiar, is Alphabet, Amazon, Apple, Meta, Microsoft, NVIDIA, and Tesla. Each of these companies has fundamentally transformed the industries they operate in, from how we communicate and consume media to the way we shop, work, and even drive. Alphabet's innovations in search and advertising, Amazon's revolution in retail and cloud computing, Apple's iconic products that have become a part of daily life, Meta's social media empire, Microsoft's dominance in software and cloud services, NVIDIA's groundbreaking advancements in graphics and AI, and Tesla's disruptive impact on the automotive and energy sectors.

1:15These titans of technology and innovation have been at the forefront of S &P 500's extraordinary performance, delivering a combined return of 75 % in 2023 alone. Meanwhile, the S &P 500 as a whole posted a return of just 24 % in the same period. Now, sign me up for an annual return of 24 % anytime, but the performance disparity between the Magnificent 7 and the S &P 500, along with the size of the MAG 7 relative to the broader index, has many investors wondering, have US markets become too reliant on the largest companies? That's the topic of today's episode. And as always, you can find detailed show notes for today's episode at thelongterminvestor.com.

2:08But today's show notes are particularly special because they feature several really good charts that I think just brings this discussion to life. So be sure to check those out. And while you're there, you can also sign up for my newsletter, which hits your inbox every other Wednesday and is filled with all my latest insights along with links to things I'm currently reading. And if you're listening and already a subscriber, go ahead and hit reply next time and drop me a note. I really enjoy hearing from readers and listeners, and I personally respond to every message I receive. Now, equity concentration at the index level isn't new.

2:47In fact, history shows us that market concentration has always been a factor in overall returns. There is a really nice chart from the Vanguard Investment Advisory Research Center that I share in the show notes that shows that since 1926, out of thousands of stocks, only a mere 72 stocks accounted for half of the market's total return. The trend holds true even when you're excluding the recent mega cap tech growth boom, because year in and year out, a select few stocks have played a significant role in driving overall return. However, the S &P 500 is witnessing its highest level of market capitalization concentration in decades.

3:33leads. Another chart I have in the show notes at thelongterminvestor.com comes from Goldman Sachs Research. And according to Goldman Sachs Research, the top 10 stocks in the U.S. now command a staggering 33 % of the S &P 500's total market value, a level of concentration that surpasses even the peak of the tech bubble in 2000. While the dominance of a handful of companies often seems to raise alarm over market health, here's where things get interesting within this research. According to the historical data from Goldman Sachs, periods of high concentration have not necessarily spelled doom for the market.

4:13And in fact, more often than not, the S &P 500 has rallied in the 12 months following these peaks of concentration. So history tells us that such concentration isn't inherently negative and can in fact precede significant rallies. But there is still the question of how our approach to diversification is impacted by a landscape where the Magnificent Seven not only shines, but sometimes seems to overshadow the rest. The concept of not putting all your eggs in one basket is foundational in investing. Yet, the balance between embracing the growth potential of the Magnificent Seven and maintaining a diversified portfolio presents an interesting challenge.

5:00In charting your course through the waters of market concentration, remember that the goal isn't just to avoid risk, but to understand and manage it. Looking beyond the market cap-weighted S &P 500 to other indices or diversification strategies could mitigate some of these concentration risks. Within the U.S. alone, diversifying beyond the S &P 500 could involve including mid-cap and small-cap stocks, or adding intentional factor weights, or perhaps even ESG exposures. Diversifying doesn't mean abandoning the Magnificent Seven. Rather, it's about complementing them with exposures that have different expected returns.

5:41In addition, most investors should have international market exposures. Now, I recognize the increasingly popular idea for investors, although I believe it to be fundamentally flawed, is that the S &P 500 offers enough global diversification because the companies earn revenue globally that directly owning international stocks isn't necessary. Now, I'd like to point out that the gain in popularity of this idea seems to be perfectly correlated with the recent U.S. outperformance, but I will avoid that rabbit hole for now. For the purposes of this conversation, international exposure offers a two-fold advantage.

6:24Not only do you get to tap into the growth potential of emerging and developed markets, but you also dilute the concentration risk tied to the U.S. market. Now, I think to this point, I have mostly covered the concerns one might have related to the S &P 500 being highly concentrated. So I would like to conclude with two ideas related to this topic that don't necessarily get as much attention. Despite all of the discussion around the Magnificent Seven's dominance, I do think it's worth pointing out that both the market cap-weighted and the equal-weighted S &P 500 indices have been closely tracking each other since the end of the last major correction.

7:04I'm including a chart in the show notes at thelongterminvestor.com from Charles Schwab that I think really illustrates this well, and the development is noteworthy for a few reasons. First, it highlights the resilience and dynamicism of the broader market. So while the Magnificent 7 will continue to play a pivotal role, the performance of the equal-weighted S &P 500 index suggests that the strength of the market's rally is not solely dependent on these tech behemoths. Undoubtedly, a welcome shift for investors who value diversification is a core part of their investment strategy. Secondly, the narrowing performance gap within the Magnificent Seven itself, with a handful of names showing varied returns, it underscores the importance of systematic rebalancing.

7:53Now, I talk at length about rebalancing in episode 144. And chances are, if you have some of these companies in your portfolio, not only have you had some really nice returns, but you also probably have some high capital gains. So that is an episode you will probably want to check out. And the reason I can so confidently say that you probably have some really nice returns is that if you happen to own companies that grow to become the largest on the U.S. stock market, their returns can be impressive. The final chart that I have in the show notes comes from Dimensional Fund Advisors, who looks at the history of stocks leading up to the point in which they joined the top 10 largest by market cap, and then what happens after that.

8:40And so from 1927 to 2023, the average annualized return for these stocks over the three years prior to joining the top 10 was more than 25 % higher than the market. Yet five years after joining the top 10, these stocks were, on average, underperforming the market. And the underperformance gap grows even wider 10 years out after joining the top 10. Now, a lot of this is because expectations about a firm's prospects are reflected in its current stock price. So positive news might push prices higher, but those changes aren't predictable and everyone knows these are great companies. So if you happen to be an owner of one of the individual companies within the Magnificent Seven and you have some nice returns, I've made it abundantly clear throughout the episode that there are a ton of resources in this episode's show notes at thelongterminvestor.com.

9:39And if you don't own these individual stocks, but you're feeling worried about market concentration, I do encourage you go check out those charts, go check out the extra links that I've put in there. And one last time, I will mention that I really appreciate the emails I'm receiving. I love the comments. So if you don't have access to my email, go ahead, sign up for the newsletter while you're there. I cannot wait to hear from you.

10:25and do not reflect the opinions of PlanCorp or BrightPlan. This podcast is for informational purposes only and should not be relied upon as a basis for investment decisions. Clients of PlanCorp and BrightPlan may maintain positions in the securities discussed in this podcast.