When we look at the equity portion of our portfolios, the largest piece is usually domestic large-cap; the S&P 500 Index is the most followed U.S. or domestic large-cap index and consists of the leading 500 traded stocks in the U.S. by market cap. Because it constitutes approximately 75% of the market capitalization of publicly traded U.S. stocks, it serves as a benchmark of American equity performance. For example, one S&P 500 component, Apple Inc., has a market capitalization that is greater than the entire Russell 2000 Index (the leading small-cap index comprised of 2,000 U.S. small public companies). A small-cap stock is usually characterized as having a market cap of $2 billion or less. Another way of saying this is that Apple Inc., by itself, is worth more than the 2,000 biggest U.S. small-cap stocks combined.
Source: Bloomberg, Data as of October 25, 2023.
Diving deeper, the S&P 500 is market-cap weighted, which means a stock within the index will gain a higher percentage weighting as the value of the company (as reflected through the company’s market capitalization) increases relative to the other companies in the index and will become a smaller percentage of the index if its value declines. For example, at the time of this writing Nvidia is the highest contributor or gainer in the S&P 500 year-to-date in 2023, rising to the sixth largest component in the index, surpassed by just five other tech behemoths such as Apple Inc. and Google parent Alphabet. The financial press has now labeled these top tech companies the “Magnificent 7” – a familiar name to fans of the Old Western film genre. As we see below, if you only hold an S&P 500 Index fund, Nvidia is now roughly 3% of your portfolio as opposed to 1% a year ago— a massive move.
Source: Bloomberg, Data as of October 25, 2023.
The “Magnificent 7” have dominated the U.S. stock market in recent years. These companies are:
These stocks are the leaders in the tech industry, although they transcend technology to some degree. Each has seen distinct benefits from strong secular trends such as the growth of e-commerce, autonomous vehicles, cloud computing, and machine learning or artificial intelligence.
The dominant run of the “Magnificent 7” has had a significant impact on market breadth. Market breadth refers to the number of stocks that are participating in a market move. A healthy market breadth is generally seen as a positive sign for the market, as it indicates that there is widespread investor participation. However, the dominance of the “Magnificent 7” has led to a narrowing market breadth in recent years. This is because the gains in the stock market have been concentrated in a small number of stocks. In fact, the “Magnificent 7” stocks now account for nearly 30% of the S&P 500 index. This means that the performance of the S&P 500 is increasingly dependent on the performance of these seven stocks.
The concentration of gains in a small number of stocks has led to concern for some investors (including us). The worry is that the index is more vulnerable to a sell-off in these seven stocks. Additionally, some investors argue that the narrowing market breadth is a sign of a market bubble. Below is a charting of the number of stocks in the S&P 500 trading above their 200-day moving average. A rising indicator above 50% indicates market strength. The indicator has weakened substantially since the summer, so we will have to see if the third-quarter earnings season can provide a boost to stock prices.
Source: Yardeni Research, Data as of October 20, 2023
We acknowledge that the 200-day moving average and other market breadth indicators are somewhat technical indicators, but it is important to be aware of the risks associated with the concentration of gains in the “Magnificent 7” stocks, especially if interest rates remain elevated. In an extended bull cycle, we’d like to see more market participation; however, the technological innovations (including the focus on artificial intelligence, or “AI”) developed by these seven tech companies should, over the long term, generate meaningful shareholder returns in our view. The S&P 500 index and other large-cap indices are still a substantially diversified equity index that gives investors meaningful exposure to growth through either ETF or mutual fund wrappers—a primary compounder of wealth. Investors must, however, be cognizant of the risks embedded within their portfolios. If an investor holds these companies individually and holds an exposure to the index, their portfolio has a greater exposure to swings in the mega-caps than it might appear on the surface. As we tell our clients, it is important to ensure that your portfolio reflects your risk tolerance and therefore these risks must be considered. If you would like to discuss this further, please call your financial advisor and we will be happy to review this and the implications for your portfolio.
The views expressed in this publication are those of the author and do not necessarily reflect the views and opinions of Cetera Advisor LLC or Burrows Capital Advisors.
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