During the past four months, investors have aggressively flocked to the biggest U.S. consumer-tech stocks for their perceived defensiveness, helping drive their lofty valuations even higher. In fact, the most highly valued public company in the U.S. today has a valuation greater than the entire U.K. stock market, and twice the size of Germany’s.
These stocks now dominate the benchmark S&P 500 Index, and their recent gains have driven the “market-cap-weighted” version of the index (in which companies with a higher market cap have more impact on the index’s performance) to significantly outperform its “equal-weighted” counterpart (in which each stock’s performance has an equal impact).
Why does this matter? Rather than providing a true defense, the clustering of performance could leave investors’ portfolios less diversified than they might think. Consider the following:
- First, investors in the S&P 500 Index may think they are getting exposure to a diversified basket of 500 companies. But today, the top 10 mega-cap companies in the index account for almost 35% of its entire market capitalization compared with 25% during the 1999-2000 tech bubble and an average of 20% over the past 35 years. This means that money deployed into the market-cap-weighted S&P 500 is increasingly a wager on the health of just a few companies—with the fundamentals of the other 490 carrying less weight.
- Second, expensive stocks keep getting more expensive, as my colleague Mike Wilson also noted this week. The market-cap-weighted S&P 500 Index as a whole has a forward price-to-earnings (P/E) ratio of about 19. The top 10 stocks have an average ratio of 28, and the top three average a staggering 66. This is a risk because these rich valuations are extremely dependent on low interest rates, which tend to make the projected value of these companies’ future earnings look more attractive to investors. Should the Federal Reserve keep policy rates higher for longer, the index may be more rate-sensitive and subject to greater volatility than many investors assume.
- Finally, the risk of over-concentration in investors’ portfolios is further exacerbated by the U.S. stock market’s growing weight in global equity markets. After nearly 15 years of outperformance, U.S. stocks currently make up about 60% of the value of all stocks in the world. With global monetary policies and economic growth rates now set to diverge—and with most non-U.S. markets priced at a more reasonable forward P/E ratio of 12 to 13—looking outside the U.S. may be a better move toward a balanced portfolio.
To sum up, U.S. stock-market performance has increasingly been driven by just a few companies that all share similar market cap, sector exposure and valuations. And with expected returns for the market-cap-weighted S&P 500 now projected at about 5.5% per year—only a couple of points above “risk-free” U.S. Treasuries—diversification may be more important than ever and may require an active approach to portfolio management.
Long-term investors should consider moving away from U.S. passive index exposures toward opportunities in small-cap, value-style and cyclical stocks. Meanwhile, tactical rebalancing could also favor emerging markets over the next six to 12 months.
This article is based on Lisa Shalett’s Global Investment Committee Weekly report from May 22, 2023, “Concentration, Divergence and Diversification.” Ask your Morgan Stanley Financial Advisor for a copy. Listen to the audiocast based on this report.