Share Market Concentration

Looking at the events that have transpired thus far this year, I’m sure many of you will agree there’s certainly been a shock to expectations. Australia has not been excluded from tackling a ‘once in a century’ global health crisis and we have officially recorded our first recession in almost 30 years.  

Over in the US, with the backdrop of a pandemic and fears of economic shutdowns, the S&P 500 benchmark plunged from its peak by about 35% earlier this year. The economy faced severe deterioration; indicated by unemployment levels increasing by record amounts, years of real GDP growth being erased within a matter of months as well as a severe drop in business and consumer confidence. Despite this, what followed was one of the sharpest recoveries in the history of capital markets.  

Source: Dow Jones Market Data

This resurgence was aided by an unprecedented response from the Federal Reserve and the US government which saw interest rates being cut to near-zero, billions of dollars being lent across markets as well as over 150 million stimulus checks being sent out to citizens. 

The S&P 500 has been able to breach the trading levels it was at pre-COVID and upon closer examination is largely attributed to the performance of the top 5 listed companies (Facebook, Apple, Amazon, Microsoft and Alphabet – Google’s parent company). 

Source: Howard Hook – EKS Associates

As a result of the pandemic, it is clear there has been an accelerated transition for businesses, households and education towards further digitisation. Amongst the key benefactors of this trend have been the big tech firms, whose products and services have become integral in the day to day lives for many of us as consumers. Their network effects and the data they collect from us giving extraordinary access into how we work, shop, relax as well as communicate.  

Meanwhile, the rest of the constituents within the S&P 500 representative of sectors such as financials, energy, utilities and industrials have underperformed. There continues to be diminishing influence, with energy for instance now making up less than 2.5% of both the S&P 500 and the Dow. The Exxon Mobil Corporation, one of the biggest oil and gas entities today and once the largest publicly traded company, recently got booted from the Dow Jones Industrials index; having been included in it since 1928.   

‘History doesn’t repeat itself, but it often rhymes’  

– Mark Twain 

Today, the level of concentration we’re seeing in the top 5 stocks of the S&P500 is far exceeding the historical average and in fact has not been seen since the dot com bubble of 2000.  

A stock portfolio that may at first seem balanced by incorporating popular index products (many of them being capitalisation-weighted), instead may have more weighting in specific sectors and individual securities than appreciated. Looking through a macro lens, this top-heavy concentration has meant there has never been more dependency on the largest components continuing to perform with strength. Inevitably, this raises the vulnerability of any unexpected shock triggering FAAAM stocks to be driven lower.  

For example, if these five FAAAM stocks collectively declined by 10%; the bottom 100 companies within the S&P 500 need to increase in value by 109.3% for the index to simply to return to its previous trading level.  

Source: BofA Global Investment Strategy, Bloomberg

‘The four most expensive words in the English language are “this time it’s different”  

– Sir John Templeton

During the dot com bubble, many of the tech leaders lacked revenue and failed to even turn a profit. This contrasts with today where they have healthy ‘cash rich’ balance sheets, high profitability as well as above-average revenue growth.  In a slow-growth world, the FAAAM have been able to remain strong with support from these fundamentals as well as a macro environment that has highlighted their advantages in financial and operational capacity.

Perhaps there remains the possibility of the FAAAM conglomerates continuing to dominate and we’ve actually come to a point where ‘this time is different’, yet investors at this stage are paying historically high valuations. At the time of writing, Apple, the largest public company in the world has a market value greater than the GDP of several developed nations including Canada, Italy, Russia and South Korea amongst others. In addition to this, Amazon continues to trade at a price-to-earnings ratio that is in excess of 115 *make a comparison to say Aussie bank stocks. These high valuations imply an expectation by investors for future profits to remain consistent and growing over the coming periods; characteristic of what are commonly known as growth stocks. 

Growth style stocks are typically companies who have had a record of relatively high earnings compared to the rest of the market whilst also generally having high price-to-book ratios. On the other hand, value stocks are those that tend to trade at levels below what their fundamentals (based off both financial and economic factors) are and perceived to have been ‘underappreciated’ by the broader market.  

Over the past decade, growth has been able to well outperform value stocks. Contrasting to recent times however, research undertaken by Eugene Fama and Kenneth French shows value over the long-term has outperformed growth for the grand proportion of developed markets, this being no different in the US.  

Source: Dimensional Fund Advisors

Even with this data, it still remains imperative to realise the only certainty in the markets’ future is that no one truly knows what’s going to happen. There are simply too many elements at play in our random and exceptionally complex world. As argued by Nassim Taleb, we as humans have a tendency to assign far too much predictability to the truly unpredictable. An example of such being stock and economic models attempting to forecast the future, which follow the premise that if they have been able to predict accurately in the past that they would likely continue doing so. Inherent in these models are a set of assumptions and thereby often a play with our own biases. Would you be confident that a coin would land heads up just because you were able to predict it doing so the last five times?  

Instead, following a diversified approach to investing ensures that idiosyncratic risk exposure from being concentrated in a specific area or security is reduced. It allows participation in all segments of the market and therefore benefit from their respective potential; no matter if perhaps a particular type of stock performs better than another over a given stage. 

A portfolio of stocks can certainly be a useful part in an investing toolkit. Yet, it remains as just that, a tool. What is more crucial is setting out a framework detailing the ideal work and outcomes to be accomplished. Thus, value and guidance can be extracted from having a discussion with your Financial Adviser about the journey you wish to take moving forward.  

Written by Nimmi Siriwardana