TOO BIG, TOO FEW(?)
February 2025
PART TWO: CAUSES AND CONSEQUENCES
Ruan Goosen - Portfolio Manager
Reuben Beelders - CIO, Portfolio Manager
In Part 1, we explored the high concentration in US equity markets, highlighting how a handful of mega-cap technology companies have become increasingly dominant. In Part 2, we examine the underlying forces that started this trend in 2008 and subsequently evolved into one of the most significant periods of market concentration in recent history.
The unprecedented concentration in U.S. equity markets - epitomised by the dominance of the "Magnificent Seven" tech giants - stems from a complex interplay of monetary policy shifts, speculative investor behaviour, and structural changes in market mechanics.
In the wake of the 2008 financial crisis, central banks, led by the Federal Reserve, turned to quantitative easing (QE) as a lifeline for the global economy. By massively expanding their balance sheets, these institutions injected unprecedented liquidity into the financial system. This flood of capital helped suppress interest rates, driving investors to chase higher returns in riskier assets such as equities.
As a result, the S&P 500 has delivered remarkable returns between 2009 and 2023, with large-cap stocks - viewed as safe havens in a low-yield environment - emerging as the biggest winners. The reduction in equity risk premium has created the perception of stability around these blue-chip companies, with forward earnings yields for top U.S. firms falling below T-bill rates by 2024. This trend reflects a growing appetite for risk, leading institutional investors to favour mega-cap stocks to make up for lower bond returns.
Moreover, the rise of passive investing has intensified market concentration. Over the past decade, passive strategies have grown to control more than 50% of U.S. equity assets under management. Because index funds allocate capital based on market weightings, the largest stocks receive an outsized share of investment. For every dollar flowing into passive funds, a significant portion automatically funnels into the top seven S&P 500 stocks. This self-reinforcing cycle fuels momentum while weakening the natural price discovery process.
When a large portion of a company’s shares - such as roughly 25% of Apple’s stock - is held by passive funds, traditional valuation checks weaken. As these mega-cap stocks rise, their increasing index weights attract even more passive inflows, reinforcing the cycle. This trend is evident in the MSCI World Index, where U.S. mega-caps now make up a substantial share of global equity exposure.
Investor behaviour has also been a key driver of this shifting landscape. The tendency to follow the crowd, or herding, has always influenced market trends. In the U.S., herding is three times stronger in the S&P 500 compared to mid- or small-cap stocks, driven by institutional behaviour and popular retail ETFs. Algorithmic trading has intensified this effect, as quant strategies focus on stocks already doing well. In 2023, algorithms contributed to nearly half of the rally in the Magnificent Seven, compared to a much smaller impact on the average S&P 500 stock. Meanwhile, platforms like Robinhood have gamified trading, fuelling a “fear of missing out” mindset that pushes retail investors into mega-cap stocks, as seen during the tech rally of 2020–2021.
Fundamental economic forces have also fuelled overconcentration in the market. In the digital age, the "winner-takes-all" nature of the tech sector is stronger than ever. Companies like Amazon and Apple benefit from network effects, allowing them to achieve near-monopolistic margins, often over 20%, compared to the S&P 500 average of about 10%. Additionally, tech leadership in areas like AI and data analytics has created formidable moats for firms like Nvidia and Microsoft, seemingly justifying their high valuations and reinforcing their dominance. This has been further supported by minimal regulation, with lax antitrust enforcement since the 2010s allowing tech giants to absorb potential rivals, like Facebook acquiring Instagram. However, the competitive landscape may shift with the emergence of DeepSeek, a Chinese AI company developing a reasoning model that could challenge U.S. tech dominance due to its efficiency and lower costs, despite some scepticism about its claims.
While these mega-cap companies continue to post strong earnings, their high valuations suggest that the market is expecting almost mythical future performance. For example, the top 10 stocks in the S&P 500 trade at forward earnings multiples much higher than the overall index, echoing the dot-com bubble era. Investors are now forecasting annual growth rates of 15% for these firms through 2030, a prediction that seems overly optimistic given the challenges of maturing markets and increasing regulatory risks.
In summary, today’s market overconcentration is the result of a perfect storm - a combination of accommodative monetary policies, the rise of passive investing, and behavioural biases that have distorted the market’s natural dynamics. While the strong fundamentals of these mega-caps justify some premium, their overwhelming dominance raises concerns about systemic risk and market sustainability.
"In investing, what is comfortable is rarely profitable." Robert Arnott
In the final instalment of this series, we’ll compare these structural drivers to historical events like the Nifty Fifty and the dot-com era, exploring whether history might be on the verge of repeating itself…and consider the ultimate question – “Quo Vadis…where to from here?”