The record degree of concentration in the US equity market has continued to rise as mega-cap companies have led the recent market rally. The five largest US companies (Facebook, Apple, Amazon, Microsoft, and Google – or FAAMG) accounted for 23% of the S&P 500 Index market capitalization in July, up from 19% in January 2020 and well above the 14% long-term average. These stocks have returned more than 35% year-to-date as of Aug. 12, leading the market into positive territory for the year. Historically, such narrow market breadth has been cause for concern, but today’s unique landscape gives us reason to be both confident and cautious.
Today’s Market Leaders Have Stronger Fundamentals
The tech-forward trends that made the market leaders into mega caps have been accelerated by the corona-crisis. These secular trends have contributed to superior long-term growth expectations, but tech companies today also have sustainable advantages that may not have existed in past episodes of concentration. Characteristics such as strong realized profitability, above-average near-term growth and low leverage have driven valuations higher as investors seek quality amid a world of uncertainty1.
Compared to the tech bubble when the forward two-year price-to-earnings ratio of the top five largest stocks reached more than 50x, the FAAMG stocks traded at just 31x earnings at the end of July. Actual profits have pulled multiples more in line with the rest of the S&P 500 Index today. As Goldman Sachs Global Investment Research reports, the outperformance of the top of the market may diminish as other parts catch up in the recovery, but less likely because a bubble bursts2.
Today’s Market Leaders Have Garnered Increased Regulatory Scrutiny
Market dominance has also invited the potential for regulation. Antitrust investigations by US Congressional committees, the US Department of Justice, and the European Commission into prominent tech companies all pose risks. Any type of regulation or scrutiny that would reduce the growth potential of these companies would likely weigh on their return potential3. As Exhibit 1 shows, historical periods of sector-specific policy risk have had a material impact on performance. Today, the exceptionally large weights of the top firms make the S&P 500 Index vulnerable to an idiosyncratic shock that would drive any of those stocks lower. For example, if the FAAMG stocks declined by 10%, in order to keep the market trading flat the bottom 100 S&P 500 stocks would have to rise by a collective 90%.
Source: Bloomberg and GSAM, as of July 31, 2020. Past performance does not guarantee future results, which may vary.
For investors, the long-term investment implications would largely depend on the outcome of what would be many years of legal action. In the near term, investors may consider moving down in capitalization to the small- and mid-cap equity space which is still tech-heavy and growth-oriented, but with less key company risk. Additionally, US investors may want to consider broadening the borders of their portfolios, identifying secular growth and strong balance sheet opportunities irrespective of domicile.
Going forward, if the rally continues as a tale of two markets with mega caps outpacing the rest of the S&P 500 Index, market breadth will continue to narrow. As the political season picks up steam, the specter of regulatory scrutiny raises the risks in extreme market concentration, even one supported by fundamentals. In our view, an investor’s best response to narrow market breadth may be expanding the investable opportunity set.