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Q2 2024 Market Commentary

July 08, 2024

Domination, Concentration, and Risk

by Timothy J. Videnka, CFA, CFP®

“It’s like déjà vu all over again.” – Lawrence Peter “Yogi” Berra

As widely followed broad stock market indices notched new all-time highs with regularity this year, we thought it would be important to, once again, highlight some common misperceptions regarding a well-known index. To the average observer, an index fund designed to track the S&P 500 index should be well diversified across its 500 constituents. The idea of getting market exposure and diversifying away company risk is valid and a core tenant of this type of investment. However, the risk profile of the index can change and needs to be monitored.

 

As the above charts from Alpine Macro illustrate, the so called “Magnificent 7” – comprising Apple, Microsoft, Google, Amazon, Nvidia, Meta and Tesla – account for 34% of the total market capitalization of the S&P 500. Clearly, there is a fair amount of individual company risk in an index that has been well diversified in the past. And one can see the evolution of this risk over time. It should be noted that each new dollar invested in this index today will see over one third ($0.34) go into these seven stocks. In these pages we profiled this issue previously (circa March 2022), not only is the current concentration at historical highs but the resulting index performance has also been driven by these few names. What do we need to be on the lookout for as this concentration unfolds? A book originally written by an MIT professor in the late 1970s may help.

The Embryo Stage of a Mania?

“By no means does every upswing in business excess lead inevitably to mania and panic. But the pattern occurs sufficiently frequently and with sufficient uniformity to merit renewed study.”
“Manias, Panics and Crashes” – Charles P. Kindleberger

A mania occurs when an asset’s price rises to levels that cannot be justified by fundamental economic principles. During such periods, investor psychology undergoes a significant shift, disregarding conventional valuations and making seasoned experts appear premature for exiting investments too early. The price surge gains momentum independently of fundamentals but valuation becomes crucial again once the bubble bursts, helping to determine the extent of potential losses. Historical examples include gold in the 1970s, Japanese stocks and real estate in the 1980s, Internet tech stocks in the 1990s, and commodities – along with U.S. real estate – in the 2000s, just to name a few. (See chart below from Alpine Macro.)

 

The “Mag 7” tech stocks are notably diverse yet they share enough common traits that investors may group them together if current bullish trends persist. Specifically, Charles Kindleberger’s framework for manias outlines four preconditions, the first three of which the Mag 7 already satisfy:

  1. Fundamental displacement: The Mag 7 were relatively small companies a decade ago, collectively valued at $1 trillion but now soaring to $10.4 trillion. They dominate their tech sectors and are poised to benefit from AI innovations, akin to their earlier gains from cloud computing. Nvidia, notably expensive due to AI-driven demand for semiconductor chips, exemplifies this trend.
  2. Difficulty in valuation: Given the Mag 7’s dominance and the as-yet uncertain benefits of AI, traditional valuation metrics are disregarded. While their valuations have not yet reached extreme levels relative to the broader market, comparisons show a narrowing gap with the S&P 500 excluding Big Tech. But this has been the case on several occasions over the past decade, supporting the view that Federal Reserve easing could significantly benefit Big Tech. Moreover, earnings multiples on these stocks are well below the stratospheric peaks reached by the Tech Four Horsemen in March 2000 and the Nifty Fifty in 1972.
  3. Broadening investor participation: The experiences of the past year have reinforced investor beliefs that the Mag 7 are highly attractive assets in almost any macroeconomic environment. They proved to be “safe havens” during the regional banking turmoil following the failure of Silicon Valley Bank in March 2023, thanks to substantial cash reserves that shielded them from the credit crunches that severely affected small businesses and commercial real estate. They are perceived as growth stocks with a competitive edge in AI innovation due to their economies of scale and substantial R&D budgets.
  4. Liquidity: Currently, monetary conditions appear tight based on financial aggregates and real long-term bond yields. However, expectations are for a shift in late 2024 into 2025. This continuation further illustrates the factors contributing to the sustained allure and market dominance of the Mag 7 tech stocks, emphasizing their resilience and strategic advantages amidst broader economic challenges.

These factors can contribute to a scenario where market euphoria and speculative fervor drive prices beyond traditional metrics, potentially setting the stage for future market adjustments based on fundamental realities.

The above section has been adapted from a November 2023 Alpine Macro Special Report, titled “Magnificent 7: Potential Mania Waiting For A Catalyst”

In Closing

If a mania ensues, stock portfolios may be taking on more risk than intended. Risk management can come in many forms. Within a stock portfolio, that holds funds, one way to understand the risk is by looking through the fund to view the underlying holdings. A prudent risk management technique is to have five percent or less in a single stock and caping sector weightings to no more than 25%.