Following a brief interlude, the Magnificent 7 stocks have once again surged to new heights following Nvidia’s exceptional earnings report: they now make up roughly 30% of the S&P 500. When adding the remaining top 10 stocks (Berkshire Hathaway, Lilly, and Broadcom), this concentration increases to about 33% of the S&P 500.
At the recent ETF conference in Miami Beach, Registered Investment Advisors (RIAs) were keen on seeking guidance regarding how to mitigate their clients’ insistence on allocating more funds to the Magnificent 7. Concerns about over-concentration were palpable.
RIAs feared that just as they were faulted for not fully capitalizing on the Mag 7 rally, they would also face criticism from clients if and when the bubble burst. RIAs hoped for a broadening of the market rally. However, this aspiration dwindled following Nvidia’s earnings announcement, extinguishing the last flicker of hope for the “diversify” advocates. The statistics speak volumes:
Major Sectors Year-to-Date (YTD):
– Van Eck Semiconductor ETF (SMH) up 20% (25% Nvidia!)
– Roundhill Magnificent 7 ETF (MAGS) up 14% (14% Nvidia!)
– S&P 500 up 5% (4% Nvidia!)
– S&P 500 Equal-Weight ETF (RSP) up 2%
Is over-concentration truly a risk? At face value, it certainly appears so. The juxtapositions are becoming ludicrous. During the ETF conference, Dimensional Fund Advisors highlighted that the Magnificent 7 stocks now match the collective market size of Japan, UK, Canada, France, and Hong Kong/China combined:
Magnificent 7 vs. The World
(MSCI All Country World Index weighting)
– Entire U.S. stock market: 63%
– Japan, UK, Canada, France, Hong Kong/China combined: 17.5%
– Magnificent 7: 17%
It seems incredulous, doesn’t it? Yet, such levels of concentration have been observed in previous periods, predominantly in the tech sector. While concentration has escalated over the past decade, it’s worth noting that in 2015, the top 10 stocks in the S&P 500 only represented 17.8% of the index, according to a 2023 study by FS Investments.
However, this was a nadir. Historically, the concentration of the top 10 stocks has often been much higher. For instance, in the mid-1960s, the concentration of the top 10 exceeded 40% of the S&P 500. During the heyday of the “Nifty 50” stocks in the 1960s and early 1970s, which included IBM, American Express, General Electric, Polaroid, and Xerox, the concentration of the top 10 stocks routinely surpassed 30%.
Concentration gradually receded over the next two decades, stabilizing at roughly 17%-20% of the market capitalization of the S&P 500 from the 1980s to the late 1990s. It surged again during the dot-com and Internet boom, propelling the concentration of the top 10 to over 25% in the late 1990s. Other countries like China, France, and Germany exhibit significantly higher concentrations in their top 10 holdings compared to the U.S.
The broadest China ETF, the iShares MSCI China ETF (MCHI), comprises over 600 stocks. However, the top 10 stocks, including Tencent, Alibaba, and Baidu, constitute 42% of the entire ETF. Similar scenarios unfold in Germany, the United Kingdom, France, and Canada.
Despite concerns, concentration has proved advantageous for index investors and U.S. investors at large. The bulk of the gains in the past year can be attributed to a handful of predominantly tech stocks. Investors who hold the S&P 500 don’t need to cherry-pick winners; they benefit passively.
Furthermore, U.S. stocks are global frontrunners, and when a select few leads, it typically results in the outperformance of the U.S. stock market vis-à-vis the global market. This is precisely what has transpired. The U.S. stock market, which comprised roughly 40% of global market capitalization not long ago, now accounts for roughly 50%. U.S. investors in broadly diversified indexes have reaped substantial rewards despite the “concentration risk.”
In essence, concentration is inherent in market cap-weighted indexes. These indexes reward winners and penalize losers. The reason behind the success of the Magnificent 7 is that they are among the most profitable companies globally, particularly in transformative technologies like AI. Primary reasons for their leadership include globalization, which streamlined supply chains, and the protracted decline in interest rates (which has halted).
Ultimately, in an era marked by scarce growth opportunities, these companies boast ample growth prospects, and investors are willing to pay a premium. Contrary to the dot-com era, the leading stocks today contribute significantly more to the earnings of the S&P 500, and their cash flow is substantially higher.
Moreover, a correction has already transpired: it unfolded in 2022. At the ETF conference, RIAs’ predominant worry was, “What if there’s a significant correction in the Magnificent 7?”
However, it’s worth noting that such a correction has already occurred. Nvidia plummeted from roughly $292 at the outset of 2022 to $112 by October of the same year, marking a staggering 62% decline. Other Magnificent 7 stocks experienced similar plunges. While another correction remains a possibility, the AI revolution is undeniably genuine. Nvidia’s sales tripled, and profits surged by 800%. This represents a bona fide revolution.
