Just hours into the new year, I received an email from a concerned investor. His worry: the state of the market—the S&P 500, in particular. With hundreds of constituent companies, the S&P index has the veneer of being well diversified. But scratch the surface, and it seems to carry more risk than investors might like. The issue is that it’s top heavy.
As a group, the top 10 companies in the S&P 500 account for more than 30% of its overall value. Apple alone is nearly 7%. That 30% concentration level has only been eclipsed twice in the past fifty years: during the 1970s Nifty Fifty boom and during the 1990s dot-com run-up. Each of those peaks was followed by a period of market malaise, so the concern is understandable.
Further compounding the concern: the fact that seven of the top 10 are technology companies. This makes it awfully easy to compare today’s market to the one we saw in 2000. Experienced investors, in fact, have been sounding this alarm for years. In 2019, Michael Burry, an investor who famously foresaw the 2008 housing meltdown, spoke out about the concentration risk in a top heavy market. “The theater keeps getting more crowded,” he said, “but the exit door is the same as it always was.”
And last year, veteran investor Jeremy Grantham wrote, “I believe this event will be recorded as one of the great bubbles of financial history, right along with the South Sea bubble, 1929, and 2000.” Notably, Grantham wrote those words in early January, before the market gained yet another 28% over the course of the year.
As an investor, should you be alarmed at the concentration in the S&P 500? Is this a sign of things to come?
While I acknowledge that the market is high, I don’t see it as the “full fledged epic bubble” the way Grantham does. There are several lenses, in fact, through which the current concentration level appears justified. Let’s start with corporate profits. Basic finance says that the value of a company should be proportional to the profits it generates. If that’s the case, then the values of these companies actually make a lot of sense. According to J.P. Morgan, those top 10 companies, which account for a 30% weight in the S&P 500 index, account for 26% of its profits. In other words, their weight in the index is almost perfectly justified by the profits they’re delivering.
And these profits are immense. In Apple’s most recent fiscal year, it generated $95 billion in profit. To put that in perspective, Apple generated more profit than 481 other companies in the S&P 500 generated in total sales.
Another pillar of finance is that a company’s value should be based not just on its current level of profits but also on its expected future profits. As a result, faster growing companies deserve higher valuations. And the top 10 group have been growing more quickly than many would have thought possible for companies of that size. Again, let’s look at Apple. Over the past 10 years, its profits have grown at an average annual rate of 14%. In contrast, earnings growth among all S&P companies has historically averaged just 6% per year.
Why are these companies so profitable? In large part, it’s due to their strong market positions. Google’s market share among search engines is regularly in the 80% to 90% range. Apple owns about half the domestic smartphone market. And in e-commerce, Amazon owns about half the market too. That gives them more leeway in pricing.
Have you noticed an increasing number of little recurring charges on your credit card in recent years—things like Apple Music or Amazon Prime? That’s another factor behind technology companies’ rising valuations. Consider Intuit, the company that makes TurboTax and QuickBooks. Ten years ago, the company sold its QuickBooks software the old fashioned way—in a box for $300 or $400—and hoped customers would upgrade from time to time. Today, in contrast, QuickBooks is sold on a subscription basis for at least $25 per month, or $300 per year. The result: much higher revenue with much greater predictability. Intuit is just an example. Many companies—especially the tech companies in the top 10—have been pursuing this same strategy.
There’s also a Covid component. The top 10, through sheer luck, are mostly in businesses that have either been unaffected or been positively affected by the pandemic. There are no hotels, restaurants or movie theaters in the top 10. This has also helped them pull away from the pack.
In short, these companies have, to a great extent, earned their strong valuations. Because of that, I’m not overly worried about the resulting concentration in the index. This isn’t Pets.com, and I doubt any of them will turn into Tyco or Enron.
But those, I don’t think, are the only points of reference. Another scenario is that earnings growth at these top 10 companies might simply slow down. If those top 10 stocks stagnated the way Microsoft shares did for 15 years, between 2000 and 2015, the result would be a massive drag for investors. This is a real risk. Recall that companies like General Electric and IBM were among the largest companies 20 years ago. But today, each is worth far less than it was then. IBM has lost about half its value over 20 years, and GE has lost three-quarters.
In looking at companies like Apple or Amazon today, it seems unthinkable that they might lose their edge. And maybe they will indeed remain dominant long into the future. But history suggests that this is far from guaranteed.
Another concern: Corporate profits are highly correlated with stock prices but still are just one component. The other aspect, which is harder to predict, is investor sentiment. What if investors decided that they wanted to pay 25 times earnings for Microsoft instead of 30? A multiple of 25 would still be way above average, but the stock would nonetheless drop 16%.
The fact that seven of the 10 are in the same industry poses a further risk. That’s because stocks in the same industry tend to move together. If investor sentiment at some point sours on tech stocks, it’s possible that all seven could experience a downturn at the same time. That represents another risk below the surface.
Will 2022 be another year in which the S&P 500 trounces every other investment? It’s entirely possible. That’s why it’s at times like this that diversification may feel most difficult. It would be much easier to go all in on the S&P 500, an investment that seems tried and true, to the exclusion of anything else. But because nothing is guaranteed, that’s also why diversification may now be more important than ever.
