The invention of market cap-weighted indices has been useful for the typical investor by offering a easy and environment friendly method to acquire publicity to fairness markets. Nevertheless, hidden beneath the floor of some market cap-weighted indices lies ranges of focus hardly ever noticed in historical past.
On this publish, we study how elevated focus ranges have traditionally impacted returns, valuations, and long-term investor outcomes — and why right this moment’s market dynamics could also be setting the stage for a well-recognized ending.
The US inventory market has reached its highest focus stage in additional than 50 years, with the highest 10 shares comprising a weighting of 36%. A number of issues might come up when a couple of firms dominate the market.
The focus within the high 10 shares necessitates that efficiency can be closely influenced by these handful of firms. Sturdy efficiency from these shares can drive the complete market increased, whereas any important declines might disproportionately drag the market down. This dynamic can generally masks the efficiency of the remaining 490 shares, resulting in a skewed notion of total market well being.
Whereas there’s all the time an urge to proclaim, “this time is completely different,” market historical past tells us that whereas the plot might change, the story typically ends the identical. On this publish, we make the most of the highest 500 US shares, weighted by market cap (High 500), to look at how the highest 10 shares have traditionally carried out based mostly on ranges of focus and valuations, and why market contributors could also be unprepared for the aftermath of present occasions.
A inventory’s placement within the high 10 could also be short-lived and unstable or it might final for many years (Determine 1). The Seventies and Eighties have been dominated by industrial giants and power firms. IBM and Exxon Mobil spent a number of many years within the high 10. The Eighties and Nineteen Nineties additionally noticed a couple of pharmaceutical and telecommunications shares enter and exit the highest 10. Even tobacco producer Altria made a short look within the high 10.
By 1999, the rise of know-how/progress firms was in full swing as the burden to the highest 10 shares rose to multi-decade highs. The 1998 to 2000 Expertise/Progress Bubble was the final nice cycle of market focus previous to our present excessive ranges. The 2000s noticed a decade of robust efficiency by worth names as a number of power and monetary firms rose to the highest 10. This got here to a crashing halt through the 2008 monetary disaster. The 2010s to current noticed a resurgence of know-how or technology-related firms that elevated the extent of market focus past that of the late Nineteen Nineties and early 2000s.
Determine 1: Largest Shares Change Incessantly Decade to Decade.
Represents the highest 10 largest shares based mostly on market cap from the five hundred largest US shares. Supply: Compustat. Calculation: Hartford Fairness Modeling Platform.
Market Cap Weight vs. Earnings Contribution
The burden of the highest 10 shares is at present 37% and has elevated at a far increased charge than their earnings contribution, which at present stands at solely 28%. This has created a big hole between their earnings contribution and weight (Determine 2).
The present hole between the market cap weight and the earnings weight is likely one of the widest since 1970. There have been two different events of a spot near this magnitude.
In August of 2020, a spot appeared as the biggest shares led the way in which after the Covid bear market, forward of the anticipated earnings that have been projected following the “keep at residence” shift in spending. On this case the burden to the highest 10 remained regular because the market continued to rally and earnings contributions caught up.
In 2000, the burden to the highest 10 additionally remained regular and earnings contributions caught up, however on this occasion firm earnings had collapsed, and the market misplaced 49%.
It’s unattainable to foretell how the present hole can be resolved, however the current hole shaped because of the weight of the highest 10 going parabolic whereas their earnings contribution has remained regular. It could take a herculean effort for earnings contribution to catch up, however it’s attainable.
Determine 2: Weight to High 10 Has Elevated Whereas Earnings Contribution Has Been Regular.
Date Vary: 12/31/1964 to 12/31/2024. Represents the highest 10 shares based mostly on market cap from the biggest 500 US shares. Supply: Compustat. Calculation: Hartford Fairness Modeling Platform.
Is it attainable for right this moment’s high 10 shares to keep up their market management? Determine 3 is a hypothetical illustration of the expansion of every inventory within the high 10 if their previous 10-year return is extrapolated ahead. If the final 10-years repeats itself, the highest 10 would improve to a weight of 73%. It might be ample to say that the present efficiency trajectory of the highest 10 shares is unsustainable.
Determine 3: Present Trajectory of High 10 is Unsustainable.
High 500 based mostly on the five hundred largest US shares. Chart makes use of present weights and previous 10-year returns and applies them for 50 years into the long run. Previous efficiency doesn’t assure future outcomes. Supply: Compustat. Calculation: Hartford Fairness Modeling Platform.
Now that it has been established that the highest 10 have reached excessive ranges of focus, we’ll contemplate whether or not focus has influenced ahead returns. We divided the High 500 US shares into the highest 10 and Backside 490. Each have been equal-weighted and rebalanced month-to-month. Subsequent, we used the weights in Determine 2 and mixed them with the ahead five-year return differential between the High 10 Equal Weight and Backside 490 Equal Weight.
For the complete evaluation, the Backside 490 Equal Weight outperformed the High 10 Equal Weight in 69% of rolling five-year intervals. After we divided our observations equally into thirds, the best ranges of focus nonetheless led to Backside 490 Equal Weight outperformance.
The third of the time the market was most concentrated, the highest 10’s weight ranged from 23% to 39%. The Backside 490 Equal Weight’s ahead five-year return outperformed after 88% of these intervals (Determine 4).
Within the center third of focus ranges, the Backside 490 Equal Weight outperformed 80% of the time. We noticed the reverse of this development within the lowest third of focus ranges.
When High 10 focus ranges stayed beneath roughly 19%, the Backside 490 Equal Weight outperformed 39% of the time, so there’s a time and place the place the chances barely favor market cap-weighting.
Determine 4: When High 10 Focus is Above 23%, Backside 490 Equal Weight Has Outperformed 88% of the Time Over the Subsequent 5 Years.
Date Vary: 12/31/1964 – 12/31/2024. Previous efficiency doesn’t assure future outcomes. Based mostly on the five hundred largest US shares by market cap. High 10 Equal Weight and Backside 490 Equal Weight are equal weighted and rebalanced month-to-month. Supply: Compustat. Calculation: Hartford Fairness Modeling Platform.
Do Historic Valuations Affect Ahead Returns?
Along with focus ranges, we additionally examined historic valuations to find out in the event that they influenced ahead returns. The worth-to-earnings ratio (P/E ratio) of the High 10 Equal Weight in comparison with the Backside 490 Equal Weight is at an excessive not seen for the reason that peak of the 2000 know-how bubble (excluding the COVID-19 interval, which affected earnings figures).
The widest valuation unfold between the High 10 Equal Weight and Backside 490 Equal Weight occurred initially of 2000 because the know-how bubble reached most inflation. Outdoors of the know-how bubble interval, the subsequent widest valuation spreads occurred this yr. Whereas valuation metrics are horrible market timing instruments within the close to time period, they’ve traditionally supplied some indication of long-term efficiency.
Determine 5: High 10 Equal Weight and Backside 490 Equal Weight Historic P/E Ratios.
Date Vary: 12/31/1964 – 12/31/2024. Based mostly on the five hundred largest US shares by market cap. High 10 Equal Weight and Backside 490 Equal Weight are equal weighted and rebalanced month-to-month. Supply: Compustat. Calculation: Hartford Fairness Modeling Platform.
When evaluating historic relative valuations, based mostly on P/E ratios of the Backside 490 Equal Weight versus the High 10 Equal Weight, the present relative valuation would rank within the high decile. Traditionally, when the Backside 490 Equal Weight has been this discounted relative to the High 10 Equal Weight, the Backside 490 Equal Weight outperformed by nearly 7% over the next 5 years, on common.
Moreover, there was just one remark the place the relative valuation was within the high decile and the Backside 490 Equal Weight didn’t outperform over the next five-year interval.
Determine 6: Backside 490 Equal Weight is Discounted Relative to High 10 Equal Weight.
Date Vary: 12/31/1964 – 12/31/2024. Previous efficiency doesn’t assure future outcomes. Based mostly on the five hundred largest US shares by market cap. High 10 Equal Weight and Backside 490 Equal Weight are equal weighted and rebalanced month-to-month. Above 0% the Backside 490 Equal Weight outperformed, beneath 0% the High 10 Equal Weight outperformed. Supply: Compustat. Calculation: Hartford Fairness Modeling Platform.
Elevated focus and valuation ranges have typically preceded intervals of heightened volatility and drawdowns for the biggest shares. In lots of the most extreme market drawdowns, the High 10 Equal Weight has underperformed the Backside 490 Equal Weight, together with the current bear market in 2022.
Determine 7: The Largest Shares Have Extra Volatility than Generally Perceived.
Date Vary: 12/31/1964 – 12/31/2024. Previous efficiency doesn’t assure future outcomes. Based mostly on the five hundred largest US shares by market cap. High 10 Equal Weight and Backside 490 Equal Weight are equal weighted and rebalanced month-to-month. Supply: Compustat. Calculation: Hartford Fairness Modeling Platform.
Not solely do intervals of excessive focus and relative valuations result in heightened volatility, however they’ve additionally led to disappointing long-term returns generally known as “misplaced many years.” There have been a number of misplaced many years all through market historical past, with most of them occurring after intervals of maximum market focus and relative valuations.
The unwinding of the focus constructed up through the Nineteen Nineties know-how/progress bubble led to a misplaced decade (Determine 8) as a result of the return of a market cap-weighted High 500 was damaging over a 10-year interval. One other misplaced decade (Determine 9) occurred after an egregious episode of market focus within the Nineteen Sixties led to a 10-year interval with damaging returns for the biggest shares, however constructive returns for the center of the market. These misplaced many years demonstrated the ability of diversification because the Backside 490 Equal Weight typically outperformed the High 500.
Determine 8: Annualized Returns for the Misplaced Decade March thirty first 2000 – March thirty first 2010.
Date Vary: 3/31/2000 – 3/31/2010. Previous efficiency doesn’t assure future outcomes. High 10represents the biggest 10 largest shares by market cap out of the highest 500 largest US shares. High 10 is equal weighted and rebalanced month-to-month. Backside 490represents the subsequent largest 490 shares by market cap weight out of the highest 500 largest US shares. The Backside 490 is equal weighted and rebalanced month-to-month. Subsequent 500 represents next-largest 500 US shares by market cap, after the primary 500 largest US shares. Subsequent 500 is equal weighted and rebalanced month-to-month. Supply: Compustat. Calculation: Hartford Fairness Modeling Platform.
Determine 9: Annualized Returns for the Misplaced Decade December thirty first 1964 to December thirty first 1974.
Date Vary: 12/31/1964 – 12/31/1974. Previous efficiency doesn’t assure future outcomes. High 10represents the biggest 10 largest shares by market cap out of the highest 500 largest US shares. High 10 is equal weighted and rebalanced month-to-month. Backside 490represents the subsequent largest 490 shares by market cap weight out of the highest 500 largest US shares. The Backside 490 is equal weighted and rebalanced month-to-month. Supply: Compustat. Calculation: Hartford Fairness Modeling Platform. *Subsequent 500 was excluded from evaluation on account of lack of shares in beginning universe.
Over the past 10 years, market cap-weighted indices have dominated the funding panorama, like previous episodes of market focus within the Nineteen Sixties and Nineteen Nineties. Whereas market cap-weighted indices have been useful for the typical investor, are these identical traders ready if we enter one other misplaced decade like those that transpired after previous incidents of market focus?
Market historical past exhibits us the continuation of this focus can be tough to realize, until we are able to envision a world the place 10 shares make up greater than two-thirds of the market into the 2030s.
Fashionable portfolio idea has taught skilled traders the advantages of diversification. Perhaps it’s time to diversify in a extra intentional method to scale back excessive market focus.
Disclosure
Hartford Funds Distributors, LLC. Member FINRA. Hartford Funds might or will not be invested within the firms referenced herein; nonetheless, no specific endorsement of any services or products is being made.
