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Weighty Issue

Adam M. Grossman

JUST HOURS INTO the new year, I received an email from a concerned investor. His worry: the state of the market—the S&P 500, in particular. With hundreds of constituent companies, the S&P index has the veneer of broad diversification. But scratch the surface, and it seems to carry more risk than investors might like. The issue: It’s top heavy.

As a group, the top 10 companies in the S&P 500 account for more than 30% of its overall value. Apple alone is nearly 7%. That 30% concentration level has only been eclipsed twice in the past 50 years: during the 1970s Nifty Fifty boom and during the 1990s dot-com runup. Each of those peaks was followed by a period of market malaise, so the concern is understandable.

Further compounding the concern: Seven of the top 10 are technology companies. This makes it awfully easy to compare today’s market to the one we saw in 2000. Experienced investors, in fact, have been sounding this alarm for years. In 2019, Michael Burry, an investor who famously foresaw the 2008 housing meltdown, spoke out about the concentration risk in a top-heavy market. “The theater keeps getting more crowded,” he said, “but the exit door is the same as it always was.”

And last year, veteran investor Jeremy Grantham wrote, “I believe this event will be recorded as one of the great bubbles of financial history, right along with the South Sea bubble, 1929, and 2000.” Notably, Grantham wrote those words in early January, before the market gained yet another 28% over the course of the year.

As an investor, should you be alarmed at the concentration in the S&P 500? Is this a sign of things to come?

While I acknowledge that the market is high, I don’t see it as a “full-fledged epic bubble,” the way Grantham does. There are several lenses, in fact, through which the current concentration level appears justified. Let’s start with corporate profits. Basic finance says that the value of a company should be proportional to the profits it generates. If that’s the case, the value put on these companies actually makes a lot of sense. According to J.P. Morgan, those top 10 companies, which account for a 30% weight in the S&P 500 index, account for 26% of its profits. In other words, their weight in the index is almost perfectly justified by the profits they’re delivering.

Those profits are immense. In Apple’s most recent fiscal year, it generated $95 billion in profit. To put that in perspective, Apple generated more profit than 481 other companies in the S&P 500 each generated in total sales.

Another pillar of finance is that a company’s value should be based not just on its current level of profits, but also on its expected future profits. As a result, faster-growing companies deserve higher valuations. The S&P 500’s top 10 have been growing more quickly than many would have thought possible for companies of their size. Again, let’s look at Apple. Over the past 10 years, its profits have increased at an average annual rate of 14%. By contrast, earnings growth among all S&P companies has historically averaged just 6% a year.

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Why are these companies so profitable? In large part, it’s due to their strong market positions. Google’s market share among search engines is regularly in the 80% to 90% range. Apple owns about half the domestic smartphone market. In e-commerce, Amazon also owns about half the market. That gives them more leeway in pricing.

Have you noticed an increasing number of little recurring charges on your credit card in recent years—things like Apple Music and Amazon Prime? That’s another factor behind technology companies’ rising valuations. Consider Intuit, the company that makes TurboTax and QuickBooks. Ten years ago, the company sold its QuickBooks software the old-fashioned way—in a box for $300 or $400—and hoped customers would upgrade from time to time. Today, by contrast, QuickBooks is sold on a subscription basis for at least $25 per month, or $300 per year. The result: much higher revenue with much greater predictability. Intuit is just an example. Many companies—especially the tech companies in the top 10—have been pursuing the same strategy.

There’s also a COVID component. The top 10, through sheer luck, are mostly in businesses that have been either unaffected or positively affected by the pandemic. There are no hotels, restaurants or movie theaters in the top 10. This has also helped them pull away from the pack.

In short, these companies have, to a great extent, earned their strong valuations. Because of that, I’m not overly worried about the resulting concentration in the index. This isn’t Pets.com, and I doubt any of them will turn into Tyco or Enron.

But those, I don’t think, are the only points of reference. Another scenario is that earnings growth at these top 10 companies might simply slow down. If those top 10 stocks stagnated the way Microsoft shares did for 15 years, between 2000 and 2015, the result would be a massive drag for investors. This is a real risk. Recall that companies like General Electric and IBM were among the largest companies 20 years ago. But today, each is worth far less than it was then. IBM has lost about half its value over 20 years and GE has lost three-quarters.

In looking at companies like Apple or Amazon today, it seems unthinkable that they might lose their edge. Maybe they will indeed remain dominant long into the future. But history suggests that this is far from guaranteed.

Another concern: Corporate profits are highly correlated with stock prices but still are just one component. The other aspect, which is harder to predict, is investor sentiment. What if investors decided that they wanted to pay 25 times earnings for Microsoft instead of 30? A multiple of 25 would still be way above average, but the stock would nonetheless drop more than 16%.

The fact that seven of the 10 are in the same industry poses a further risk. That’s because stocks in the same industry tend to move together. If investor sentiment at some point sours on tech stocks, it’s possible that all seven could experience a downturn at the same time. That represents another risk below the surface.

Will 2022 be another year in which the S&P 500 trounces every other investment? It’s entirely possible. That’s why it’s at times like this that diversification may feel most difficult. It would be much easier to go all in on the S&P 500, an investment that seems tried and true, to the exclusion of anything else. But because nothing is guaranteed, that’s also why diversification may now be more important than ever.

Adam M. Grossman is the founder of Mayport, a fixed-fee wealth management firm. Sign up for Adam’s Daily Ideas email, follow him on Twitter @AdamMGrossman and check out his earlier articles.

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Roboticus Aquarius
Roboticus Aquarius
10 months ago

There has always been a large amount of concentration in the S&P500, as you note. For that reason I’ve always split my US investments roughly a third each between Large Cap, Mid Cap, & Small Cap. Some might say that Small Cap is too small to take on a third of one’s core investment, but I would claim it’s more diversified than the S&P500. Over the very long run, this has been an effective strategy, though you’ll note that it didn’t do as well as a pure S&P500 investment this past decade. I’m ok with that too.

One caveat to the 1/3 each statement is that I have 10% of my portfolio self-directed, rather than governed by my IPS. For a long time, most of that has been in funds that skew heavily midcap such as Vanguard’s Multi Factor Fund, and Min Volatility Fund.

Wesley Davis
Wesley Davis
10 months ago

I have very much been a Boglehead for the last 20 years even though my S&P 500 index fund took a 37% hit in 2008. I rode out the market correction. It’s a financial philosophy that has served me well.
Yes, Apple has defied expectations year after year. Though it might appear impolite to say so, Apple’s stellar performance has less to do with their fine design and more to do with the cheap coal (cheap manufacturing energy) and cheap labor of China where much of their hardware products are contract manufactured. That arrangement appears to be at an end. And there’s always an example to heed about pulling out of the market too early and losing some upside to the stock market. But I would argue the current scenario is much different than 2008. The huge national debt means the Federal Reserve has less ability to intervene like it did in 2008. It’s not even clear that The Fed will be able to get inflation under control because rising interest rates on Treasury bonds may mean the “taper” will translate to less income to the federal government to meet its ongoing obligations. The Fed might have taper its taper plans and let inflation run for a while. The Shiller P/E Ratio is at a historical high. Is this the same kind of irrational exuberance of the dot-com bubble? I have been telling anyone who will listen for the last year and a half that a “market correction” is imminent. So, I’ve been wrong for the last year and a half. In that period I switched to an indexed fixed income fund and lost in comparison to the S&P 500 index fund. Now I’m in index funds for TKIPS and money markets and losing 7% to inflation. We got rid of all debt. I’m retired and I sleep well at night. I don’t have confidence that The Fed will be able to make the financial markets right because it no longer has the means. There’s nothing wrong with a good S&P 500 index fund. After the “imminent” market correction I will be a Boglehead once again.

Roboticus Aquarius
Roboticus Aquarius
10 months ago
Reply to  Wesley Davis

Your actions sounds a little like Wade Pfau’s bond tent approach, assuming your retirement was relatively recent. It’s always good to revisit one’s appetite for risk. Even though I disagree with you on the direction of the market, I try to stay agnostic on that point.

Mr Moderate
Mr Moderate
10 months ago

Excellent reminder, again, Adam. Checking my end-of-year statement, I see my emerging market portion and Small cap and European slices still aren’t performing as well as the S&P. For the stock portion of your portfolio, what does anyone recommend going to the S&P only?

Andrew Forsythe
Andrew Forsythe
10 months ago

Thank you, Adam, for another helpful article. It motivated me to check the top 10 stocks of the broader Vanguard Total Market Index Fund. As you would expect, it’s not quite as concentrated, but still pretty top heavy. Apple is at 5.6% of the total, and the top 10 are at 26%: VTSAX – Vanguard Total Stock Market Index Fund Admiral Shares | Vanguard

Maybe time to add more of something like the Extended Market Index Fund, where the top holding is at 1.2% and the top 10 make up only 7.9%: VEXAX – Vanguard Extended Market Index Fund Admiral Shares | Vanguard

David Powell
David Powell
10 months ago

Excellent insights, as always. Grantham’s bubble observations seem most spot on looking at the Nasdaq index companies, SPACs, and cryptocurrencies though SP500 is clearly above even its modern average CAPE. (I wish someone would freely publish CAPE for int’l and value slices of the market.)

One head wind for earnings at some companies soon may be the minimum corporate tax of 15%.

steveark
steveark
10 months ago

My dad, who has long since passed, gave each of my three children $2,000 in a Janus actively managed technology fund in 1998 or thereabouts. Not a slam on Janus, everybody has funds like this, and everybody should know they are risky. This fund was heavy into the companies that were just about to go over the cliff in 2000. It just got back to $2,000 a couple of years ago. If he had given them an S&P index fund worth the same amount back then it would be worth over $20K now. Or if he had given them the same amount of Walmart stock, one of his favorites, they’d have over $14K now. Instead they’ve got around $3,000 after 25 years! It was a good lesson to all of us about the danger of being concentrated in one hot sector of the market.

Ginger Williams
Ginger Williams
10 months ago

Thank you, Adam. I feel much better now about having rebalanced my portfolio last week. It felt silly to reduce the S&P 500 index fund when it’s doing so well, so it’s good to read again about the risks of being too concentrated in one area of the market. Wish my employer’s plan offered a total stock market fund, so I didn’t need to juggle four stock funds.

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