Should We Be Concentrating on Stock Market Concentration?

We have been involved in the stock market for almost thirty years. We are always fascinated by the subjects that capture everyone's attention.

Some subjects are always a focus, like interest rates, unemployment, and the activity of the Federal Reserve.

As the stock market evolves across a cycle, though, there are topics that are always particular to that specific period.

One topic that has come to the forefront recently is the concept of stock market “concentration”.

You have probably heard about it a lot, specifically with the media talking about the seven largest stocks in the S&P 500, dubbed the "Magnificent Seven."

For those of you who don’t know – this was also the name of a 1960 American Western film with an incredible cast including Yul Brynner, Eli Wallach, Steve Mcqueen, and Charles Bronson…

In the stock market today, the "Magnificent Seven" refer to Apple Inc. (NASDAQ: AAPL), Microsoft Corporation (NASDAQ: MSFT), Amazon.com, Inc. (NASDAQ: AMZN), NVIDIA Corporation (NASDAQ: NVDA), Alphabet Inc. (NASDAQ: GOOG), Meta Platforms, Inc. (NASDAQ: META) and Tesla, Inc. (NASDAQ: TSLA). 

Alphabet and Meta are the companies formerly known as Google and Facebook, respectively.

What has the analysts so interested in these stocks is that they make up an increasingly large percentage of the total market cap of the S&P 500.

Here is a table showing that percentage…

From the chart, you can see that the top seven stocks in the index are at a much more significant percentage of the index than they had ever been before.

A corresponding chart shows the difference in returns for these seven stocks in 2023 versus the other 493 components of the S&P 500…

You can see that while these stocks have been outstanding, the rest of the stock market wasn’t as strong.

The criticism is that this leaves the stock market vulnerable and that the recent rally in the market is unlikely to be sustained. Many point to the last time we were at these levels – back during the Internet Bubble in 1999/2000 – and how the stock market had a massive crash afterward.

Should we be concerned? Does this mean the stock market is about to crash?

The answer is that it is something to monitor for sure, but it is not a sure sign that a market downturn is likely. Think of it as a "yellow flag" instead of a "red flag.”

One aspect to consider is why the stocks have increased so much; the answer is EARNINGS!

Several of these companies have seen massive positive earnings revisions.

Here are the earnings revisions charts for NVDA and META…

Both companies have seen massive increases in earnings estimates. For NVDA, they have tripled in less than a year!

When you see these kinds of positive revisions, the stocks go higher. It also means that they may get more expensive but not as expensive as you would think just by looking at the stock chart.

All but TSLA have seen improving or stable earnings estimates among the other five stocks.

This is important because stock prices are much more "vulnerable" when going up because of their multiple valuations without the benefit of earnings.

Think of the “multiple” as the level of enthusiasm about the company. The earnings are a measure of the “worth.”

Suppose the stocks were just up on the multiple without a corresponding improvement in earnings. In that case, they are vulnerable to a quick change in investor opinion. The growth in earnings makes this much less likely.

How does this period compare to the last time we reached these concentration levels in 2000?

Of the seven most prominent companies today, only one – MSFT – was one of the seven largest back in 2000.

The others included a couple of technology companies (Cisco Systems, Inc. (NASDAQ: CSCO) and Intel Corporation (NASDAQ: INTC)) along with several large leading companies like General Electric Company (NYSE: GE), Walmart Inc. (NYSE: WMT), Exxon Mobil Corporation (NYSE: XOM) and Royal Dutch Shell (NYSE: SHEL).

The relative valuations for the two periods show that the current average price-to-earnings ratio for the Magnificent Seven is approximately 31x forward EPS estimates. The highest ratio is for TSLA at over 50x earnings, but all the rest are under 40x.

This implies that the companies can achieve these estimates, but as we demonstrated above, they have good momentum.

Looking at trailing earnings, it is 10 points higher or 10x EPS, with NVDA leading the pack at more than 90x earnings.

What were the valuations back in 2000?

Back then, the average price-to-earnings ratio was 60x times!

Also, back then, we weren't seeing the earnings growth and revisions that we have seen recently.

Undoubtedly, this group of stocks – especially with the recent moves – are due for a breather. Many of them have reached highly oversold levels.

We are less concerned about comparing to the prior period, where we saw similar concentrations. The combination of earnings growth and pricey (but not stratospheric) valuation tells us they are unlikely to take down the stock market in the intermediate term.

One last note of caution. We mentioned that only one company is on the list now, as well as in 2000 – MSFT.

Three of those companies – CSCO, INTC, and GE – have never seen the highs they saw back then…

We think something similar could happen with this current group of market leaders. These are great companies, but there is a solid chance that at least one or more have seen their highs for a long time!