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Exploring big tech market leadership

A historical analysis of concentrated results in the S&P 500 Index

INSIGHT ARTICLE  | 

Recent narrow market rallies have led investors to focus on the impact of the largest stocks in major market indices. While concentration is hardly a new concern, the contribution to return this year from a handful of big tech stocks (FAAANM) has been staggering. As this narrow market dominance has continued for an extended period of time, many investors are tempted to abandon portfolio diversification and buy the “winners”.  At the same time, many articles have expressed a cautionary note regarding the extreme concentration and lack of breadth.   We postulate that dominance often does not last very long, with recent winners usually falling out of favor eventually. Through further analysis, we continue to believe that remaining invested in a thoughtfully diversified portfolio – and allowing the market to pick winners and losers – remains the best strategy over the long term.

Introduction

Index concentration has been a popular topic this year as investors continue to focus on the disproportionate impact a few large companies, broadly referred to as “big tech” companies, has had on the markets. The performance of these big tech (and tech-based consumer) stocks, which represent a significant weight in the S&P 500 index, accounts for more than 100% of the index’s returns through September of this year.

Company

Average Weight (YTD)

Return (YTD)

Contribution to Return (YTD)

Facebook

2.1%

27.6%

0.6%

Alphabet (A+C)

3.3%

9.7%

0.3%

Amazon

4.0%

70.4%

2.3%

Apple

5.5%

58.8%

2.8%

Netflix

0.7%

54.5%

0.3%

Microsoft

5.5%

34.4%

1.8%

FAAANM

21.1%

46.4%

8.0%

S&P 500

100.0%

5.6%

5.6%

Source: Bloomberg, as of September 30, 2020

A basket of these large technology companies is often referred to by the acronym FAAANM – Facebook, Alphabet, Amazon, Apple, Netflix and Microsoft. Together, this group has contributed 144.4% of the S&P 500’s year-to-date return. Therefore, the remaining companies that constitute the index have, on average, detracted from the overall return. 

This staggering statistic raises concerns about portfolio construction, most notably for those with a significant allocation to U.S. large cap equities. With six names driving the majority of the index’s performance this year, investors might be justified in asking whether owning a diversified basket of securities adds any benefit compared to just holding these six names. However, some historical perspective is in order. There have been similar levels of index concentration before, but such levels have been relatively limited in persistence over time.  

Historical Concentration of the S&P 500

Looking at the weight of the top one, three, five, 10 and 20 stocks in the S&P 500 at the end of each year since 1990 illustrates that concentration amongst the top stocks is not a new occurrence and that the level of concentration fluctuated over time. However, this year has seen an elevated level of concentration. The most recent aggregate weights in all baskets mentioned below, with the exception of the top 20 stocks, are significantly higher than their historical means and approaching the historical maximums over the sample period. The top three stocks – Apple, Microsoft and Amazon – reached their highest aggregate weight at any point throughout the sample period.

Source: Bloomberg, as of September 30, 2020.

Year-End Weight in the Top n Stocks (end of each year)

 

Top 1

Top 3

Top 5

Top 10

Top 20

Mean

3.4%

8.5%

12.4%

20.2%

31.2%

Maximum

5.2%

12.0%

16.7%

25.3%

37.9%

Minimum

2.5%

7.0%

10.7%

17.5%

27.0%

Range

2.7%

4.9%

6.0%

7.8%

10.9%

Last (9/30/20)

4.6%

12.0%

15.5%

22.7%

32.9%

Source: Bloomberg, as of September 30, 2020.

On average, the top five and 20 stocks at the end of the previous year have contributed 16.2% and 34.9% of the annual total return of the S&P 500 over the next year, respectively.  Although this year’s numbers are only through September 30, the contribution to return from the top five and top 20 stocks exceeded any other point in the sample period. For the top 20 stocks, after this year’s contribution to index return of 106.1%, the next closest were in 2000 (99.8%) and 1994 (80%).

The magnitude of this contribution is staggering, and we do not believe that the long-term success of such a large market can continue to rest on the back of just a few stocks. Accordingly, allocating to just a few names rather than thoughtfully diversifying introduces a high level of idiosyncratic risk that often does not justify the potential returns.

Past performance does not indicate future performance and there is a possibility of a loss.

Outcomes from Concentrated Markets

Historically, periods of high concentration in the S&P 500 were followed by poor outcomes for investors. However, we caution against implying causation here – we believe that the S&P 500’s forward returns and its level of concentration were likely a result of investor sentiment and prevailing economic conditions that coincided with periods leading up to major recessions, such as in the early nineties with the dot-com bubble and the 2008 global financial crisis.

Illustrating this point, the table to the left shows that periods of high concentration (in brown and red) have generally been followed by poor returns (red). Lower concentration (green) has been followed by periods of positive performance (green). 

Source: Bloomberg, as of September 30, 2020. *Annualized. Past performance does not indicate future performance and there is a possibility of a loss.

For example, in 1995, there was relatively low concentration and returns in the following one, three, and five years were high. Soon thereafter, the story was the contrary – 2000 saw incredibly high concentration and was followed by rather disappointing outcomes for investors.

The Rise of “Big Tech”

Since 2014, when the last member of the group was added to the index, the FAAANM basket grew nearly six fold, while the S&P 500 more than doubled. Excluding the FAAANM basket, the S&P 500 generated slightly lower returns at 81%. 

Source: Bloomberg, as of September 30, 2020. Past performance does not indicate future performance and there is a possibility of a loss.

An important driver of the group’s outsized returns has been earnings growth. Shown below, the price-to-earnings ratio (P/E) for the FAAANM basket has continually exceeded that of the S&P 500, and the gap has widened in recent years as investors show a willingness to pay an increasingly higher price (P) for each dollar of earnings (E) these companies generate. In fact, the current gap between the S&P 500 and its ex-FAAANM counterpart is one of the largest ever seen.

Source: Bloomberg, as of September 30, 2020. Past performance does not indicate future performance and there is a possibility of a loss.

While the FAAANM stocks have been able to compound returns substantially faster than the S&P 500—notably, during the S&P 500’s periods of flat and negative earnings growth from late 2015 to early 2017 and during 2018 and 2019—big tech is far from cheap, especially relative to the broader market.

Conclusion

Concentration in the S&P 500 is not new, both by the weight to the top 1/3/5/10/20 stocks and their contribution to index returns. While “big tech” stocks have proven their ability to compound earnings over time, which partly justifies the high multiples they command, they are certainly expensive, especially on a relative basis. Furthermore, building a portfolio of just a few names comes with greater risk in terms of volatility, particularly to the downside. Instead, we recommend a thoughtfully diversified portfolio as the best way to capture long-term equity returns without the high risk of possibly choosing the wrong stocks for that moment.

Wealth Management Services Disclosure

The sole purpose of this document is to inform, and it is not intended to be an offer or solicitation to purchase or sell any security, or investment or service. Investments mentioned in this document may not be suitable for investors. Before making any investment, each investor should carefully consider the risks associated with the investment and make a determination based on the investor’s own particular circumstances, that the investment is consistent with the investor’s investment objectives.   Information in this document was prepared by DiMeo Schneider & Associates, L.L.C. and although information in this document has been obtained from sources believed to be reliable, RSM US Wealth Management LLC, DiMeo Schneider & Associates, L.L.C. and their respective affiliates do not guarantee its accuracy, completeness or reliability and are not responsible or liable for any direct, indirect or consequential losses from its use. Any such information may be incomplete or condensed and is subject to change without notice. The Frontier EngineerTM and Mission Aligned InvestingTM are registered trademarks of DiMeo Schneider & Associates, L.L.C.

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