By Tim Courtney, Chief Investment Officer
We’ve discussed the increasing concentration of the US markets for several quarters. Ten U.S. companies make up about 35% of the S&P 500 Index. 1 The stock market has grown in a way that has caused data providers to change the way they classify stocks so that the market doesn’t appear distorted in analysis and reporting.
Morningstar recently changed the way it classifies and plots stocks on their market map.2 The market has shed about 3,000 publicly traded firms since 1996 when there were 7,000 names.3 The market has fewer small companies but also fewer large companies. Many data providers now separate large companies into two groups: Large Caps and Giant/Mega Caps. The large cap category starts at roughly $70 billion in market cap and higher, with only about 200 companies now meeting that threshold.4
Are we on our way to the S&P 200? Or how about the S&P 50, or 5? Are recent winners destined to outperform and take up more and more of the market? History says probably not. Throughout the last several decades, the largest 10 names in the market have frequently changed. Looking back 10, 30, and 50 years an investor will see a changing list of companies at the top.5 It is why market indexes don’t lock in on just 10 names, and why all indexes change their constituents over time.
A diversified portfolio will necessarily include some or all these top 10 names, especially as they are about 20% of the world’s stock market capitalization.6 But since history suggests that the names at the top will change, a diversified portfolio shouldn’t have a focus on them either. An investor should consider that much of these companies’ success, growth and future prospects are already reflected in their stock prices, meaning they will need to exceed already elevated expectations to outperform moving forward.
We can make an analogy between favored stocks and sporting event favorites. The Los Angeles Dodgers won the World Series last year, own a loaded roster and have an extremely healthy budget. They are the clear favorite to win the World Series again this year. Even so, betting odds imply that there is about a 3 in 4 chance that a different team will win the World Series.7 It is not easy to repeat in a competitive league. The last team to do it was the New York Yankees 25 years ago. The most likely outcome is that a team from the rest of the field will win.
Similarly, it is not easy to repeat outperformance in equity markets. Competition, changing consumer tastes, regulation and unforeseen events all combine to make staying on top difficult. And like sports betting, in which a successful bet on the favorite will provide a lower payout than a successful bet on a team from the rest of the field, stocks that are already favored (i.e., have high valuations) need to exceed expectations for their returns to outperform the field.
When it comes to investing, we should take the field and be diversified. Concentration in the favorites historically has not been a successful bet. If you have questions about markets or your portfolio please reach out to your Exencial advisor.
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S&P 500® Index (S&P 500®) is widely regarded as the best single gauge of large-cap U.S. equities. The index includes 500 leading companies and covers approximately 80% of available market capitalization.