The United States stock market goes through periods of concentration and expansion. We’re currently in an extreme period of concentration.
The S&P 500, tracked by the C Fund, has 500 large company stocks and accounts for about 80% of overall U.S. equity exposure.
However, it is not weighted equally, but instead is weighted by market capitalization, which means larger companies are weighted more heavily in the index. For example, both American Express and Apple are within the S&P 500, but Apple is weighted about 18 times more heavily in the index compared to American Express.
If Apple stock goes up in price and American Express goes down in price, Apple’s weighting will be even higher and new money into the index will flow even more into Apple.
During the Dotcom Bubble of 2000, five stocks accounted for 18% of the S&P 500 company index, and they were primarily concentrated in tech stocks. This declined for many years as excessive valuations went down, but now twenty years later, we reached a new peak, where five stocks account for 22% of the S&P 500 company index.
We have to look back several decades into the middle of the 20th century to find a time when the S&P 500 index was this concentrated. Equity markets were less developed and diversified back then, and companies like AT&T and IBM dominated the index. They ended up deeply underperforming from those high peaks, when they were very large and priced for perfection.
So, U.S. equity markets, particularly as represented by the C Fund, find themselves in a quandary. The index is more concentrated than it has ever been in modern history. Microsoft, Apple, Amazon, Alphabet, and Facebook are collectively worth 22% of the 500-company index.
During the run-up to the 2000 peak, growth stocks (mainly tech stocks) outpaced value stocks. But on the way down, growth stocks underperformed.
During the run-up to the 2007 peak, value stocks (mainly financial stocks) outpaced growth stocks. But on the way down, value stocks underperformed.
During the run-up to the 2020 peak, growth stocks (again led by tech stocks) outpaced value stocks. And then during the crash so far… value stocks underperformed. So, the divide between growth stocks and value stocks, and particularly the top five stocks vs everything else, has only widened during this cycle, unlike the previous two cycles.
There are equal-weight versions of the S&P 500, such as the Invesco S&P 500 Equal Weight ETF. It takes the same 500 companies but weights them equally rather than weights them by market capitalization. Over the past three years, the normal version weighted by market capitalization has outperformed the equal-weight version by over 19%, meaning that the top 5 companies have substantially outperformed the average of the other 495.
This hasn’t always been the case. The equal-weight version has outperformed the market-weight version since its inception in 2003, but only in the past few years has it started to severely underperform, as these top 5 stocks concentrate more valuation than most other stocks.
If we look at some of these top 5 stocks, we see that their prices are becoming expensive compared to their fundamentals.
Here’s Microsoft, the largest of the five. The black line represents the stock price, while the blue line represents what the stock price would be if the stock traded at a historically average multiple of annual earnings:
And here’s Apple, the second largest:
Lyn Alden is a financial writer and an engineer, and holds a bachelor’s in engineering and a master’s in engineering management, with a focus on financial modeling and resource management. She specializes in analyzing and presenting financial data. Her investment work can be found on LynAlden.com.