What History Tells US About Investing in Concentrated Mega Cap Markets

Mentioning the extraordinary returns of the ‘Magnificent 7’ stocks in 2023 and the high concentration of the largest companies is not exactly an earth-shattering piece of information in market circles. However, we thought it would be helpful to examine other periods of narrow market breadth that were at or near today’s extreme and explore what it may mean for returns over the next few years. Spoiler alert: not necessarily bad for the stock market but often not so great for the index and the mega cap leaders.

The first three quarters of 2023 were characterized by historically narrow market leadership. The “Mag 7” makes up approximately 29% of the entire S&P 500 market capitalization. Examining top 5 stocks, and they trade at some of the loftiest valuations on record dating back to 1952. Like every period where this develops, arguments are made about why this outperformance is justified and can extend further. Of course, that is possible, but the probabilities are not favorable. Yes, these are world class companies that are well managed and have bright futures but that is not our measurement. Our measurement is based on valuations and relative to other opportunities. This is not a narrative to recommend selling stock, it is about improving odds through how one structures their equity allocation.

Here is some data regarding periods of narrow market breadth: [Source: Bloomberg, Pacer Advisors]

a.??? In 2023, the five largest companies were responsible for 67.18% of S&P total return. [9/29/23]

b.??? The Mag 7 was responsible for 84.31%. [AAPL, MSFT, GOOG, AMZN, NVDA, TSLA, META]

c.???? Common Sense: when the biggest stocks outperform, their weighting in index increases and thus going forward, they will have an even larger impact on index performance [positively or negatively]

d.??? Large Cap Top 5 Capitalization Relative to Trailing P/E Ratios: Since 1952, the ratio has only been higher than today one time: The Dot Com Bubble. [Today top 5 over 80% higher multiple than the rest of large cap companies.]

It may be time to consider something other than market cap weighting.? To highlight what often happens after a period such as today’s environment, we can compare a market cap index such as the S&P 500 with the S&P Equal Weight Index. Note that this means both strategies own the exact same stocks, yet equal weight are underweight the highly valued leaders and overweight the rest of the index. Today, this lowers an investor’s trailing P/E dramatically, from 21.93x to 17.68x. [9/29/23]

Following quarters of extremely narrow market breadth, looking back to 1989, the equal weight index outperformed the S&P by an average return of 304bps. However, with that short time horizon, and yes, one year is short in investing, it is a challenge to predict when this better performance may occur. In fact, equal weight only beat the index 44% of the time. [Bloomberg] When extending to a three-year time frame after the narrow leadership, research by Pacer Advisors has annual return outperformance of 455bps, or 10.75% vs. 6.20%. This occurred a more robust 83% of the periods.

Of course, an investor is always looking for strong probabilities of picking up excess return, but a savvy investor is also looking at volatility mitigation. During these three-year periods that follow narrow markets, the S&P Index posted negative returns in exactly 1/3 of all observations. During those periods when the three-year index returns were negative, the decline was by a cumulative 23.81%. Logically, this is when the highfliers not only underperform the equal weight, but they fall back to earth and since the weighting is so large a portion of the index, the result is poor vis a vis the equal weight comparison.

To make our point, today we demonstrated the cap weighted index versus the equal weight of the same stocks. There are many strategies and ways to “tilt” a portfolio away from the narrow leaders but the takeaway here it that investors should be cognizant of the potential risk of holding outsized positions based on recent excellent performance. Finally, please note the vast difference between examining a one-year period versus the three-year cycles: just because we see what we believe is a fundamental mispricing does not mean markets address it as quickly as we may like. In fact, the mispricing or overvaluation can extend further. That is why we prefer tilts rather than totally liquidating strong companies and most importantly, patience. Employing discipline and patience increases the probability of improved returns with less volatility.