investment insights
Market concentration and return dispersion at a turning point
Key takeaways
- Equity market concentration – focussed on the Magnificent Seven – is high, and performance dispersion amongst stocks significant. Unusually, this has coincided with low equity volatility. Historically, such high concentration levels have tended to mean revert, with markets correcting
- The promise of AI, tech sector competitive advantages, strong profit margins and the strategic importance of these sectors amid tense geopolitical rivalry provide structural support for the status quo
- Yet current market momentum, and the valuation gap between growth and value stocks, look stretched to us. Changing interest rate regimes can also drive sector, style and regional rotations into areas that have lagged
- These dynamics argue for investment diversification and disciplined portfolio rebalancing. A less concentrated equity market could usher in a stronger year for active investment managers in 2024.
The S&P 500 has risen by over 20% in the past 12 months, led by the performance of the Magnificent Seven US tech stocks1. Outstanding gains in the shares of these companies, unified by their potential to benefit from breakthroughs in AI, have created a highly concentrated rally. The dispersion in performance between the Magnificent Seven and the rest of the market has been very significant, underscoring the transformative power of AI in reshaping industries and market expectations.
Equity market gains have stalled in recent weeks amid rising geopolitical risks and concerns that persistent inflation could derail the prospect of rate cuts. While today’s high levels of market concentration are supported by solid fundamentals, historical trends suggest that it often experiences mean reversion. This raises a pivotal question. With the unique advantage provided by AI, will this time be different? Is today’s concentration a phase, or will the AI-driven advantage these firms hold prove sustainable, even in the face of historical market patterns? Will other sectors be able to catch up and reduce return differences?
Micro drivers: scale, globalisation and regulation
Concentration in financial markets is part of a broader, long-running trend in US corporate concentration, which has been a feature of the country’s economy over the last century, according to a study by the University of Chicago. Competitive advantages in the technology sector can largely be attributed to the network effect, a phenomenon where a product or service gains additional value as more people use it. Social media platforms exemplify how the network effect can drive market dominance. Network effects and high switching costs have contributed to creating ‘moats’ around existing ecosystems, and a ‘winner-takes-all’ environment.
Read also: IT’s about valuations
Compared to past periods of concentration, many dominant firms have also shifted from being based on tangible to intangible assets. Intangible assets can scale faster, benefit from fast adoption from customers and have more flexible business models. The macro environment has also contributed to large companies flourishing and in turn to concentration. Globalisation has opened up new markets for dominant companies.
An important question is how dispersion in styles and sectors relates to interest rate changes. A regime change in interest rates can signal a shift in the economic cycle, which can lead investors to rotate into stocks that are better suited for the new economic environment.
A ‘winner-takes-all’ environment in a world of strategic competition
While market concentration can stay elevated for some time, it has been always challenged. The past two episodes of extreme market concentration not only saw sharp reversals but also ended in equity bear markets because the drivers of the concentration reversed. In 2001, idiosyncratic effects led the technology sector to correct, thereby not only reversing concentration but also triggering a broader based correction.
Read also: Q1 2024 outlook video
Compared to previous episodes of market concentration like the tech bubble, current market concentration is in our view justified by better fundamentals. Today’s dominant companies are much more profitable than those of the tech-bubble era. The net profit margin of the S&P 500’s largest 10 companies stands at 28% today, versus 11% in 2000.
The micro drivers of market concentration – factors at the company or industry level that promote the dominance of a few firms in their respective markets – also remain supportive. Incumbents in the digital economy have exerted considerable control over new entrants through strategic partnerships, investments and leveraging existing platforms. In a fractured world, driven by geopolitical tensions and strategic competition, we believe countries are also incentivised to promote their technological champions and less prone to rule against monopolistic power.
Demanding valuations and stretched momentum call for diversification
What might drive a turning point in equity market concentration? We examine two key investment factors. First, the extent to which the valuation of growth companies is stretched relative to the rest of the market. Second, how much the outperformance of the top-performing companies exceeds that of the broader market.
In summary, while some factors continue to support high market concentration, we still see a risk of reversal in both momentum and growth factors. Any move higher in rates or rate expectations increases the risk that stretched momentum and growth factors will reverse, challenging today’s high level of concentration.
Portfolio implications
In today’s environment, investors may be nudged by market concentration to focus narrowly on the biggest companies, thereby under-diversifying their portfolio. However, we believe in maintaining an optimal level of diversification: balancing current outperformers with the possible winners of tomorrow.
Read also: Key risks for investors 2024
With momentum having been strong and looking vulnerable to a reversal, we believe it is now appropriate to risk-manage portfolio exposure. A less concentrated market coupled with some dispersion is likely to provide successful active managers with more opportunities to add value through stock selection in 2024.
To read our full analysis, please click on the pdf link on the top right-hand side of this page.
1 Apple, Alphabet, Microsoft, Amazon, Meta, Nvidia, Tesla.
Important information
This is a marketing communication issued by Bank Lombard Odier & Co Ltd (hereinafter “Lombard Odier”).
It is not intended for distribution, publication, or use in any jurisdiction where such distribution, publication, or use would be unlawful, nor is it aimed at any person or entity to whom it would be unlawful to address such a marketing communication.
Read more.
share.