S&P 500 Concentration Craziness: Can the Outperformance of the Magnificent 7 Continue?

February 20, 2024

If you read DWM's 4q23 Market Commentary, you are already familiar with the term “Magnificent Seven.” If not, these are Apple, Microsoft, Amazon, Alphabet, Meta, Nvidia, and Tesla, tech stocks that soared +111% in 2023 and are continuing strong into 2024. The massive performance of a handful of stocks has caused the S&P 500 to become very top-heavy – the top 10 companies now account for 33% of the total value of the S&P 500 index, a level of concentration that hasn’t been seen for 50 years! For reference, the combined weight of the top 10 companies peaked at 25% during the dot-com bubble. The Magnificent Seven alone have been responsible for 40% of the stock market’s gain since the start of the year.

The separation between extreme valuations of just a few companies and the remainder of the market have many people divided into two main camps. Optimists say that it is typical for bull markets to be led by a small group of hot stocks and while these companies are trading at multiples well above market averages, these companies in particular have histories of trading at higher valuations and their unique competitive advantages and strong cash flows justify the high prices.  Pessimists say that these companies have been caught up in the buzz around AI and are now in a micro-bubble that will pop when the excitement dies down.

Many stock market indexes, including the S&P 500 index, are market cap weighted meaning the components of the index with larger market caps (total dollar market value of a company’s outstanding stock) contribute more to the overall performance reflected by the index. The advantages of this method of calculation over equally weighting all the companies in the index are that the market’s opinion on each stock’s relative value is reflected and, in theory, greater weightings are attributed to large well-established companies that provide lower volatility. The downsides include that as stock prices rise, companies can have an excessive weighting and funds that track the index may be forced to buy overvalued stocks to reflect the index.

The big names in the news have drawn so much attention that many investors may be overlooking the opportunities elsewhere. If we look under the hood of the S&P500, we find that it is really just the big names like the Mag 7 at the top that have lofty valuations. In fact, when we focus on the price to earnings ratio (P/E), a measure of evaluating the stock price of a company as seen on the chart below, large-cap growth is trading at over 140% of the 20-year historical average P/E! That’s pricey! On the flip side, small cap is actually trading at a discount and thus may represent opportunity. Another opportunity may be found in the international space where the price discount compared to U.S. stocks has never been greater!

The chart below shows that even if the big players in the Magnificent Seven run out of steam, there is evidence to suggest that the rest of the market may catch up to them rather than all tumbling down together. The cycle of companies growing, leading the index up with their larger weights, and new technologies and disruptors taking their place is part of the reason the S&P 500 has been strong over the years. While we are seeing an abnormally high concentration at the top of the index, on average the S&P 500 has risen 14.3% in the year following peak contribution from the top 10 stocks as seen in the graph below.

The extreme concentration of the S&P 500 goes to show that even an index of 500 companies may be a misleading benchmark to compare to a diversified portfolio as it can be largely influenced by just a handful of stocks. That’s not even to mention that it is only reflecting large-cap, US stocks to begin with. DWM promotes the benefits of a diversified portfolio to protect investors from volatility and risk in any one area of the market. For more info on benchmarks and appropriate ways to gauge how your portfolio compares to them, see this prior blog.

U.S. large-cap stocks have been a top performing asset class for much of the last decade and continues to show strong returns now, meaning that a diversified investment portfolio will generally be lagging in returns. It is easy to get locked into the current status quo and think why not fully invest in something like the S&P 500 to maximize returns? However, the current trend has not always been the case and will not continue to be the same forever. For the decade January 2000 – Dec 2009, U.S. large-cap stocks underperformed almost all major asset classes (see chart below). A diversified portfolio with a relatively conservative mix of 50% bonds and 50% global equities outpaced the U.S. large-cap market by an average of 5% per year for that decade.

Just because large-cap stocks are leading the pack in recent years does not mean investors should abandon a smart, diversified approach to their investment portfolio. No asset class, sector, style, or individual stock will remain on top forever. A diverse portfolio maintains exposure across a broad range of the investment environment in turn reducing volatility and allowing the investor to benefit from the best performing assets even as they rotate in and out of favor over time.

Our investment management team here at DWM is made up of CFA charterholders. As such, we believe in prudent portfolio management which adheres to a diversified approach and not one that takes big bets on a few select areas. We know that with this diversified approach, it’s inevitable that we won’t beat each and every benchmark year-in and year-out, but we can be capable of producing more stable and better risk-adjusted returns over a full market cycle. Further, we are confident that our disciplined approach puts the client in a better position to achieve the assumed returns of their financial plans over the long run, thereby putting them in a position to achieve much sought after long-term financial success.

Detterbeck Wealth Management is a fee-only financial planning / wealth management company with offices located in Palatine, IL (Chicago area) and Charleston, SC areas serving clients locally and across the country. To contact us about setting up an appointment, please see our contact us page