For several months I have explored the growing dominance of a handful of US technology companies and the distortion this has created for global stock markets. Since the start of 2023, the Magnificent Seven stocks[1] have contributed more than three quarters of the S&P 500‘s 44% return and just three (Nvidia, Meta and Alphabet) have provided well over half of these gains (figure 1). This strong performance has seen the septet grow to nearly a third of the overall US market size and almost a fifth of the global stock market[2] – well above the peak of the dot com bubble when the largest seven tech stocks made up around of a fifth of the S&P 500 index weight.
Driven by global reach and strong fundamentals – the current market champions are far more profitable and better capitalised than those that led in 2000 – they have also gained increasing momentum from the rise of passive investing (figure 2). Assets in global index-based funds overtook those invested in active strategies last year according to Morningstar, while the passive proportion in the US has now risen to around 60%.
The result is a market that has become increasingly narrow, creating headwinds for active managers and rising concentration risks for passive investors.
Global trend
Although headlines have centred on the Magnificent Seven, rising concentration is not only a US phenomenon. Markets have become increasingly narrow across the globe with the largest emerging market companies contributing an even bigger share of five-year index returns than in the US, according to Morningstar data, although this has been in the context of much weaker performance. In Europe, where the ten largest holdings now account for nearly a quarter (23%) of the index[3], market concentration is at its highest since the 2008 Global Financial Crisis.
A key difference is that the European top ten are drawn from five different sectors, compared to the US where the majority are either Information Technology or Communication Services stocks. European equities are also cheaper, trading on a forward P/E of 13.4x vs. 21.4x for the US market – a record 40% discount.
The two biggest companies in Europe, Novo Nordisk and ASML, have been long-term holdings in our portfolios and generated very strong returns for SKAGEN Vekst and SKAGEN Global, respectively. The latter has also owned Microsoft and Alphabet for over a decade, so we and our clients have benefitted from the strong run that these companies have been on to reach where we are today.
Implications for investors
Why does it matter that stock markets have become narrower and what, if anything, can investors do about it? Periods of high concentration are not unusual as the chart above illustrates, yet it also highlights that extreme levels similar to the ones we see today have previously coincided with significant market crashes (2000 and 2008).
Rising concentration encourages herding behaviour as investors fear missing out on returns, which creates bubbles when share prices aren’t supported by fundamentals. The Magnificent Seven contribute 20% of the S&P 500’s total earnings compared to 8% for the equivalent stocks in 2000, meaning that their valuations are lower than during the dot com bubble (weighted P/E of 40x, compared to 52x[4]) but still high by most traditional measures. They are therefore vulnerable to any earnings disappointment. We saw this during the August sell-off as investors’ concerns about the huge investments being made in AI were intensified by Alphabet, Amazon and Tesla reporting profits that fell short of expectations.
Passive investors tracking popular global indices may think that they are diversified with lower risk but are in fact heavily exposed to US technology. They are also increasingly reliant on a shrinking number of these expensive stocks to generate returns and investor sentiment towards them remaining positive.
For stock pickers, it has become harder to beat a market whose returns are generated by a handful of mega-cap stocks. The challenge is even greater for value managers like SKAGEN who must balance the undeniable quality of these businesses against the price we must pay to own them.
Regulatory limits also prevent active managers from having as high exposure to today’s largest stocks as the index (even if they wanted to), but a recent Morningstar study found that a high degree of portfolio concentration is necessary to deliver the best returns in periods of narrow market leadership[5]. This echoes earlier research that active funds with above-average concentration tend to perform best[6].
In our funds, the ten largest holdings typically represent 30-50% of assets but they are diversified across sectors and geographies to help manage risk, with additional downside protection provided by cheaper valuations. Most importantly – and unlike index-based strategies – companies are selected and sized for investment based on merit rather than simply market capitalisation. Despite the short-term challenges created by a highly concentrated market, we believe this is the best way to maximise long-term returns for our clients.
All info as at 31/07/2024 unless stated.
[1] Nvidia, Apple, Microsoft, Alphabet, Meta, Tesla and Amazon
[2] MSCI All Country World Index weightings
[3] MSCI Europe Index
[4] Forward P/E of Bloomberg Magnificent 7 Total Return Index vs. Aggregate forward P/E Microsoft, Cisco Systems, Intel, Oracle, IBM, Lucent and Nortel Networks
[5] Concentration in the European Equity Market, Morningstar, 2024
[6] On the Industry Concentration of Actively Managed Equity Mutual Funds, Kacperczyk et al, 2005 and Best Ideas, Anton et al, 2021