March 21, 2024
Led by the Magnificent Seven stocks that have captured investor attention this year, the concentration of market capitalization in the biggest US equities is the highest in decades. While some may fear it’s a sign of risk, the market has often rallied after bouts of high concentration, according to Goldman Sachs Research.
The 10 largest US stocks now account for 33% of the S&P 500 index’s market value, well above the 27% share reached at the peak of the tech bubble in 2000, Ben Snider, senior strategist on the US Portfolio Strategy macro team in Goldman Sachs Research, writes in the team’s report.
The current concentration has helped drive a period of exceptionally strong US market returns. The S&P 500 has generated an annualized total return of 16% over the past five years, compared with a 30-year annual average of 10%. The top 10 stocks have accounted for more than a third of that gain. Still, today’s top stocks trade at lower valuations than the largest stocks did at the peak of the technology bubble, according to the report.
Despite the strong returns, many clients have expressed anxiety about the extreme current degree of market concentration relative to recent history,” Snider writes.
Is market concentration good or bad?
Goldman Sachs Research found that while investors usually think of elevated concentration as a sign of downside risk, the S&P 500 rallied more often than it declined during the 12 months following past episodes of peak concentration.
Combining their bottom-up equity database with research into factor returns by University of Chicago professors Eugene Fama and Kenneth French, our researchers examined S&P 500 market cap concentrations over the past century and found seven episodes in which the 10 largest stocks exhibited “extreme” concentration.
In most of these periods, stocks continued to rally after reaching peak concentration, our analysts note. The most recent episodes of this, in 2009 and 2020, coincided with sharp improvements in the macroeconomic outlook. In 1932, peak concentration marked the bottom of a major economic downturn, with the S&P 500 rising sharply in the subsequent months.
There are similarities between prevailing conditions today and the episodes in 1973 and 2000. Unemployment is low, and concentration is rising alongside strong equity market returns. “In each of those episodes, the peak of equity market concentration also marked the peak of a bull market, and the economy entered recession with the subsequent year,” Snider writes.
However, the 1964 experience shows that an ongoing bull market can continue to move higher even as market concentration declines. After market concentration peaked that year, both share prices and the US economy remained healthy for an extended period, according to the report.
Are US stocks overvalued?
It’s also the case that valuations of the largest stocks remain well below previous highs, the report notes. Today’s 10 largest stocks trade at a collective forward price-to-earnings (P/E) multiple of 25x, well below the peak valuations carried by the largest stocks in 2000, 2020, and the middle of 2023.
Valuations also appear lower on the basis of the premium the largest stocks trade at relative to the rest of the S&P 500 — the 35% valuation premium today is well below the 80% premium recorded in the middle of 2023 and the 100% premium of 2000.
While it’s true that the degree of market cap concentration is higher today than the peak reached in 2000, the largest stocks carry much lower multiples than during the tech bubble. Today’s valuations are similar to those carried by the largest stocks in 1973, but the current market leaders “generally have higher profit margins and returns on equity than the top stocks in either 1973 or 2000,” Snider writes.
Momentum during periods of high concentration
One common pattern across the market concentration episodes was the influence of momentum. The momentum factor refers to the tendency of trending stocks to continue moving in the same direction. In each episode, our researchers found that momentum rallied as the large market leaders outperformed, increasing in weight relative to the rest of the market and lifting market concentration. Then, as market concentration peaked and declined, so did momentum.
The momentum factor has performed well in the current episode, gaining 12% year to date and 19% during the past 12 months, as measured by our long/short S&P 500 momentum factor. That’s weaker in magnitude and duration than past market concentration episodes, when momentum returned 42% on average prior to peak concentration. The trailing two-year momentum rally also falls far short of the rallies that have preceded other periods.
Historically, investors have done well investing in momentum laggards (i.e., stocks with low momentum) even during market downturns, according to the report. In 26 peak-to-trough momentum reversals since 1930 — when our long/short momentum factor declined by at least 20 percentage points in a three-month period — the low momentum laggards appreciated in absolute terms in every instance.
The rationale is that when markets start selling off, investors flee the stocks that are seen to be the most vulnerable to the cause of the market downturn and crowd into stocks perceived to be safe havens, boosting the long/short performance of momentum. When the outlook improves and the market rebounds, they then rotate out of those leaders and back to the laggards.
“Today’s combination of elevated market concentration and recent momentum outperformance has furthered investor concern that a sharp drop in the largest stocks will lead to a market downturn,” Snider writes. “But history shows that ‘catch up’ episodes are much more common than ‘catch down’ experiences.”
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