Monthly Market Commentary
The Double-Edged Sword of Concentration in the S&P 500
Philip Blancato, Chief Market Strategist, Advisor Group
2022 began tumultuously after coming off an extended period of exceptional growth as stocks climbed off the pandemic lows through muted volatility. The looming prospects of tightening historically loose fiscal and monetary policy as well as rising interest rates have caused unrest in markets, as investors reexamine both valuations in a higher interest rate environment and what inflation levels not seen in four decades could mean for consumers.
From an asset allocation standpoint, 2022 presents a number of challenges many active investors have yet to experience in their careers. The Fed funds rate has remained near zero since 2009 (with the exception of a brief lift off that began in early 2016 and reversed at the onset of the pandemic in late 2019). Therefore, the shift to a regime of rising interest rates is an unfamiliar one for many market participants. In part supported by this low interest rate regime, large cap equity returns have remained strong and consistent over the past several years, leading most asset classes.
The S&P 500 Index, which returned over 28% last year, has been among the top asset classes by total return for much of the last decade. The Index is market cap weighted and domiciled in the US, so it is dominated by big technology names. Due to their size, a select few names accounted for an outsized portion of total index return: Apple, Microsoft, Google, Tesla, and Nvidia in 2021; Apple, Microsoft, Amazon, Facebook, and again, Nvidia in 2020. 1 Economic and financial conditions over those years were favorable for mega caps, and as such, these constituents enjoyed almost two years of price/earnings multiple expansion, much of it deserved because of accelerated adoption of their platforms and super-charged earnings growth.
Over the last two years the top five names in the index have had a significant impact on the overall return of the S&P 500 Index.
- In 2020, the top five names returned ~71% on average, responsible for ~62% of total index return.1
- In 2021, the top five names returned ~65% on average, responsible for ~31% of total index return.1
Concentrated contributions from the top names in the index are nothing new, however, over the last fifteen years, outside of 2020-2021, the impact of those few high performing names have been significantly smaller. During the calendar years when index returns have been top-heavy, the contribution from the top five constituents has ranged between 9% and 24%, which, while large, is clearly less than the influence they’ve had over the past two years.
The 2020 leaders were the largest and among the most significant Covid-related beneficiaries. These companies saw their depressed share prices, the result of the initial market rout, appreciate dramatically as retail investors stuck at home poured into the market and Wall Street underestimated the potential for these firms to continue accelerating in an unforeseen pandemic market environment.
Three of these names, Apple Microsoft, and Nvidia, were able to nearly repeat this performance again in 2021 thanks to larger secular trends benefiting mega cap tech. As these companies benefitted from those trends, they continued to grow and gain influence over the index. For example, Apple doubled its market capitalization from early June 2020 to its current $2.8 trillion valuation, which now represents about 6.8% of the S&P 500 Index. Similarly, Microsoft grew nearly twice its size in under two years, and now accounts for approximately 6% of the index.1
The persistently low interest rate environment has also made fixed income allocations far less attractive when compared to index tracking funds. Why settle for low, single-digit yield when a market tracking index fund will easily net 10-12%, if not 28%, in such an environment? You wouldn’t, investors didn’t, and billions of dollars poured into index funds, the largest portions of which went to the largest constituents, further growing their influence.
In fact, NVDA was the only equity to appear in both the top five names by weighting as well as the top fifteen names by absolute return in the S&P last year. This suggests the difficult part of beating the index is not finding stocks with the potential to outperform but competing with a handful of companies with large index weights with above average returns. 1
This is an environment in which an investor would have to take on concentrated risk in order to generate similar returns to the broader index, which opens investors up to risks that could otherwise be solved through diversification. Diversified portfolios have a low probability of achieving the same result as the equity market when returns are so concentrated, as exposure to anything outside of large cap growth stocks would detract from total returns.
After a decade of strong equity market returns, we feel now, more than ever, it is prudent to maintain a diversified asset allocation, but recognize the inherent challenges of doing so. Yet, 2022 has not seen the same success for the top index names that we experienced in the prior two years, and with the recent volatility, we expect market leadership to broaden out over the long term. History would suggest that the highest capitalization companies may not dominate performance for the third year in a row, and we would urge investors to allow diversification to continue to guide you through what may continue to be a volatile year ahead.
S&P 500: The S&P 500® is widely regarded as the best single gauge of large-cap U.S. equities and serves as the foundation for a wide range of investment products. The index includes 500 leading companies and captures approximately 80% coverage of available market capitalization.
Index performance does not reflect the deduction of any fees and expenses, and if deducted, performance would be reduced. Indexes are unmanaged and investors are not able to invest directly into any index. Past performance cannot guarantee future results.
Investing involves risk, including the potential loss of principal. No investment strategy can guarantee a profit or protect again loss. In general, the bond market is volatile; bond prices rise when interest rates fall and vice versa. This effect is usually pronounced for longer-term securities. Any fixed-income security sold or redeemed prior to maturity may be subject to a substantial gain or loss. Vehicles that invest in lower-rated debt securities (commonly referred to as junk bonds or high-yield bonds) involve additional risks because of the lower credit quality of the securities in the portfolio. International investing involves special risks not present with U.S. investments due to factors such as increased volatility, currency fluctuation, and differences in auditing and other financial standards. These risks can be accentuated in emerging markets.
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