Market Update: Does Concentration in Top 5 Stocks Signal Imminent Crash?
In this report you will learn:
- Are technology stocks the place to be in the current environment?
- What similarities do we see between today’s stock market and that of year 2000?
The five largest stocks in the S&P 500 have returned +37% this year. The other 495 stocks have returned -4%.* This recent disparity has contributed to these five stocks making up an unusually large percent of the index. The chart below illustrates this concentration, currently at 24%. The last time the market exhibited similar behavior was during the dot-com bubble that collapsed in 2000. The concentration in top 5 stocks was 18% then. Does this imply that the stock market is approaching another large decline?
While similarities exist with the dot-com bubble, there are also some major differences. First, the largest companies are generating very strong cash flows and have some built-in advantages during the pandemic. In 2000, the market was inflated on overly optimistic expectations of the new internet age. Second, most stocks are participating in the rally off the March lows, just not to the same degree as the five largest stocks—Microsoft, Apple, Alphabet, Amazon and Facebook. In the year prior to the 2000 peak, the percent of stocks going up with the market was declining rapidly. The divergence indicated that the handful of largest stocks was keeping the market afloat. That divergence currently being absent suggests the probabilities for a near-term crash are not high.
One implication can be derived from the current disparity in market returns: the returns from the largest stocks will likely lag the market over the next decade or so. When the positive opinion on certain stocks becomes a consensus, lofty expectations are priced into the stock. Exceeding those expectations is a rare occurrence. Looking at the rotation of the largest stocks from one decade to the next is quite interesting and shows how hard is its to stay at the top in terms of market capitalization.
In 2000, the five largest stocks in the S&P 500 were General Electric, Exxon, Pfizer, Citigroup, and Cisco. Astonishingly, none of these stocks is currently above their price in 2000, and only Exxon is even in the top 20 of today’s S&P 500, coming in at 17. In 1980, 7 of the 10 largest companies were in the energy sector. Historically low oil prices have remedied that. Also, the steepening of the technology curve is creating new companies all the time. Google and Facebook were founded just 22 and 16 years ago, respectively.
Here’s a specific example of lofty expectations: Apple’s price-to-earnings ratio (the most common valuation metric) is just above 32 currently. This means one must pay 32 times one year’s worth of earnings to buy shares in Apple. For much of the past decade, this number ranged between 9 and 18. The last time it was this high was in 2007, when it hit 37 right before financial crisis. The stock lost over half of its value in the ensuing decline, before going on to have a great decade. It’s not a matter of whether Apple is a great company or not; it’s whether it is appropriately priced at this time.
Moving on, I would be remiss to not talk about the election before ending this report. COVID-19 has distracted us from politics for much of the year, but the time has come. Generally, there is not much predictive value in applying politics to stock market analysis, and this time will likely be the same. However, if Biden does win, the market will likely view his tax policies negatively. This may be priced in prior to the election if his lead in the polls holds up. If the polls tighten between now and then, it will likely be an interesting night like we had four years ago. Let’s hope it doesn't turn into interesting weeks or months due to debated election results. It is 2020, though- why would we expect anything to be normal?
In the end, the only way to navigate the uncertainties of valuations and politics is to maintain an appropriate level of stocks in your portfolio, stay diversified, rebalance when necessary, and over-weight the more attractively valued stocks. This will allow you to meet your long-term goals with a much smoother ride along the way.
*Market capitalization weighted basis through September 8, 2020
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