Market Concentration in the Fall of COVID
by Jason Vaurio, Senior Investment Research Analyst
At the height of the COVID-19 market meltdown it would have seemed farfetched to say that the S&P 500 Index would be sitting with just under 10% gains for the year at the end of August. Surely we must have found a vaccine and administered it to the global populous with impossible efficacy and speed! It turns out a miracle cure or vaccine wasn’t the shot in the arm required for the S&P to rebound to new highs; all it took was an aggressive Fed, significant fiscal stimulus and the largest tech companies in the world to continue their dominance in the market. Though if we peel back a layer, we’ll find that the market’s reliance on tech growth is strikingly similar to that of the dot-com craze of the late 1990s/early 2000s.
The five largest publicly-traded companies in the world, measured by market cap, are: Facebook, Apple, Amazon, Microsoft and Alphabet (Google) aka “FAAMG.” At the beginning of the year these tech giants accounted for 16.7% of the market-cap weighted S&P 500 Index. Today that number stands at 23.9%. After free-falling with the rest of the stock market in the first month of the shutdown, tech stocks have ascended with exceptional velocity.
The S&P 500 Index is now up +9.7% year-to-date. The largest components of the index, FAAMG, have gained +56% year-to-date through August, propping up the performance of the broader market. Excluding these five companies from the index, the S&P would have returned a paltry 0.9%.
This market bifurcation can be explained, in part, by the COVID-19 shutdown and focus on social distancing. With brick & mortar stores effectively shut down in the spring and summer months, consumers directed their spending to online retailers. Businesses and employees were more likely to purchase additional hardware and software that would lessen the burden on a work-from-home labor force. All of these behaviors helped large tech companies capture an extra slice of the pie. But the amount of market concentration and large valuations of these tech mega caps should be cause for some concern.
Since the end of 2019 the FAAMG have added $2.7 trillion to their collective market cap – eight months to add $2.7 trillion. To put this breathtaking growth into context, in the five years prior to 2020 these titans of tech grew by a combined $3.2 trillion. The 10 largest components (including FAAMG) of the S&P 500 now account for 29% of the index’s total market cap, eclipsing the 26% concentration at the height of the dot-com bubble. The big five tech companies have the same amount of influence on the S&P 500 as the bottom 370 stocks in the index.
When the S&P 500’s performance is fueled by a handful of large stocks, the overall index return can mask the underperformance of the other ~495 stocks in the index. This is referred to as “narrow” market breadth and increases the concentration risk of the index. If (or when) those few names begin to lose their momentum, the broader index is more susceptible to large downturns. This scenario played a role in the dot-com crash.
Though the FAAMGs continue to grow their revenues and generate cash, stock returns are ultimately based on how much investors are willing to pay for that stream of cash flows. Price-to-earnings, price-to-book and price-to-sales ratios continue to stretch beyond near and long-term averages. This is especially evident in technology stocks; the S&P Information Technology Sector Index currently trades at 34.5x earnings, well above its 20-year average of 25.2x. On average, the FAAMG stocks are priced at 60.3x earnings.
While it’s natural to see parallels between the present day market and the tech-fueled delirium of the dot-com bubble, there are stark differences from 20 years ago. These are not unprofitable “.com”-suffixed companies fresh off their IPOs. The tech companies driving performance today are profitable, growing businesses with revenue streams diversified across tech segments (retail, communication, internet advertising, business software, etc.). These contemporary colossi of computing are responsible for bringing smartphones and tablets into our everyday lives and the network effect has helped them develop a stranglehold on internet advertising and cloud-based storage. The sustained low interest rate environment has minimized borrowing costs and spurred massive investments into their business operations.
It is always important to remember that starting valuation is an important determinant of future returns. Current elevated valuations negatively affect forward-looking risk/reward expectations. Investors often have a tendency to extrapolate recent trends too far into the future and any disruption to these trends can induce a downturn in stocks. A well-diversified portfolio that includes a combination of global equities and safer assets such as bonds is recommended to help withstand a potential market correction.