TOO BIG, TOO FEW - PART 1

PART ONE: MARKET OVERCONCENTRATION RISKS

Ruan Goosen - Portfolio Manager

Reuben Beelders - CIO, Portfolio Manager

"Those who do not remember the past are condemned to repeat it." —George Santayana

Philosopher and poet George Santayana's warning echoes in Benjamin Graham's The Intelligent Investor, and feels more relevant than ever in current financial markets. The U.S. equity landscape reflects previous episodes of irrational exuberance—from the Dutch tulip mania of 1636 to the housing crisis of 2008 - but with a modern twist: unprecedented concentration in the "Magnificent Seven" (Mag7) and AI-driven valuations disconnected from near-term cash flows.

At the time of writing, the U.S. equity market is experiencing significant overconcentration, driven largely by a handful of mega-cap technology companies commonly known as the "Magnificent Seven" (Mag7), namely Apple, Microsoft, Amazon, Alphabet (Google), Meta (Facebook), Nvidia, and Tesla. These giants now dominate major indices like the S&P 500 and MSCI World, shaping market performance and investor sentiment.

The Mag7 now accounts for approximately 30% of the S&P 500 with a combined market value of approximately $11.8 trillion - roughly the equivalent of the Japanese, UK, and Canadian stock markets combined. Further, these stocks account for 20% of the All-Country World Index (ACWI), exceeding the combined weight of the seven largest non-U.S. countries in the index.

*Schroders: The case for and against US stock market exceptionalism (19/12/2024)

This level of concentration is rare, with few examples outside the late 1960s and late 1990s, when a handful of companies held similar market power.

The MSCI World Index, designed to represent global equity performance, has also shifted significantly due to this concentration. U.S. equities now make up around 70% of the index, with the Mag7 playing a central role in this weighting. This skew towards U.S. tech giants raises concerns about the diversification of the index, and its vulnerability to sector-specific downturns.

What we sought to understand were the factors that led to this overconcentration. The technology sector has experienced exceptional growth, with tech companies now making up about 32% of the S&P 500’s market cap. This dominance reflects not only strong earnings but also the rapid escalation of valuations, suggesting that future growth expectations may already be priced in. Additionally, U.S. households have invested an historically high proportion of their net worth in equities, making the market more vulnerable to negative news and potential corrections.

The current economic environment, with supportive monetary and fiscal policies, has boosted investment in these leading firms. This has driven strong stock price gains, but it has also caused performance to become more concentrated in fewer sectors and stocks. As a result, while market indices may appear strong, the underlying risk has increased due to this concentration.

This overconcentration creates concerns about systemic risks and market volatility. A decline in any of these key stocks could have a disproportionate impact on overall market performance due to their significant weighting. Investors should be aware of the potential for heightened volatility and the risks associated with such a concentrated market structure. Additionally, overconcentration in a portfolio—particularly when limited to a single country or sector— undermines the principles of diversification.

?Take the example of an ice-cream maker and an umbrella maker: although these are two distinct companies, their performances could be closely linked if they are both impacted by the same economic forces, such as seasonal consumer behaviour. This illustrates that owning seven different companies is not true diversification if all investments react similarly to market changes. When adverse events affect a specific sector or region, the entire portfolio can suffer, exposing investors to systemic risks that could be mitigated through a more diversified allocation strategy.

In conclusion, the U.S. equity market is currently dominated by a small group of mega-cap technology companies. While these companies have contributed significantly to market gains, their dominance also presents risks that investors should carefully consider. Moreover, these risks are not limited to the U.S. equity market and could have contagion effects on global assets.

In investing, patience is not simply a virtue; it is a necessity. Warren Buffett

In the next instalment of this series, we explore the question, “How did we get here?” and in our final piece, consider the ultimate question – “Quo Vadis…where to from here?”