About 70% of world market capitalisation is now attributed to the ‘Magnificent Seven’ stocks1. Should investors be worried about this level of concentration?
It was a 2004 documentary on the US fast food industry that introduced the phrase ‘Super Size Me’ to the lexicon. It tracked the effects of unchecked over-consumption of fast food on an individual’s physical and psychological wellbeing. Twenty years later and equity investors are undergoing a ‘Super Size Me’ type journey of their own. This time the excess consumption centres on a narrow cohort of US companies and the damage being wrought is a distortion in stock valuations and a concentration in the source of index returns.
The growing popularity of lower cost (relative to active management) index investing has and continues still, to fuel the rise of the Magnificent Seven. As passive investment funds have taken in new money, they have simply accepted the prevailing share price when making purchases. Further, the more a company is valued the more a passive investment fund will buy of that company, creating an upward spiral in prices that makes no objective assessment of its value.
A highly concentrated market
When concentration gets this extreme, speculation about the bubble bursting inevitably arises. When this has happened, it has tended to give way to some years when active managers, particularly those investing based on value, enjoy a bull run. If the public loses trust, amid the chaos of a burst bubble, and money starts to flow out of index funds this could speed a share price collapse as fast as the ascent. A heightened regulatory regime and public scrutiny of big tech companies, and AI in general, as well as geopolitical factors are among headwinds waiting in the wings.
Investing while waiting
Comparing charts of equal-weight indices, which neutralise the concentration effects of larger companies, with market cap weighted indices, it is clear that equal weight markets outperform over the long term. It is also true that avoiding the largest stocks has been a sensible approach when concentration levels have peaked. This is because for the most highly valued companies much of the good news is already priced-in to its share price at that point. The years following the dot.com bubble burst of 2000, for instance, were glory years for value managers and in many ways established the power of the hedge fund sector. This was an era when good stock-picking was rewarded and when there were lots of undervalued stocks poised and ready to outperform the market.
Periods when the equal weight measure markedly underperforms tend to arise amid points of serious stress or bubbles (such as the Global Financial Crisis, the Covid pandemic, the Gulf War of 1990-91 and dot.com bubble). Since March of last year, we have seen the equal weighted S&P 500 and MSCI World noticeably underperform their market cap weighted versions7. This is without any apparent significant stress in the world, so does this point to a bubble or just interpreting too much about historical relationships?
While the market waits for the Mag 7 bubble to burst or run out of steam, we continue to remind our investors of the virtues of diversification and demonstrate why the biggest stocks, by market capitalisation, do not always generate the best returns over the long run.
