Mitch on the Markets

January 17th, 2022

Is the Stock Market Too Concentrated?

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Many investors have likely seen stories or headlines about massive U.S. companies making up a disproportionately large share of the U.S. stock market. For instance, maybe you’ve seen this statistic, or one like it, before: as of December 31, 2021, the 10 largest stocks in the S&P 500 accounted for 30% of the index’s total value. In other words, just 2% of large-cap U.S. companies account for 30% of the benchmark large-cap index.1

The concern that follows is also quite common – is the stock market too concentrated, with the index’s performance ultimately being decided by just a handful of companies?

Let’s consult the data. Over the past five years, the influence of the biggest companies has been apparent: the annualized performance of the S&P 500 (which is market-cap-weighted, meaning the biggest stocks have more influence) was +18.47%. But if you weigh all 500 companies equally instead of by market cap, the annualized performance drops to +15.73%. On an annualized basis, the roughly 3% spread is significant.

However, if you zoom out further and compare the 20- and 30-year annualized returns of a cap-weighted versus an equal-weighted S&P 500, here’s what we find:

Big companies having a big influence over the index is a relatively new phenomenon. Five of the biggest S&P 500 companies – Apple Inc., Microsoft Corp., Nvidia Corp., Alphabet Inc. (Google), and Tesla Inc. – accounted for roughly one-third of the S&P 500’s +28.7% return last year. This trend is significant short-term, but long-term, the data suggests capital will eventually rotate from high valuation (growth) to low valuation (value) names.

In 2022, there is a key factor to consider, which is that the Federal Reserve now appears likely to start increasing interest rates in the first quarter of this year and to begin trimming its ~$9 trillion balance sheet perhaps by summer. Higher interest rates and generally tighter monetary policy could create some headwinds for high valuation stocks, including some of those that reside at the top of the S&P 500 by market cap. Since many high valuation names arguably trade at high multiples because the discount rate for future earnings is so low, a higher discount rate makes future earnings less valuable today.

For investors, the insight here is that active management will be important in 2022, in my view. At Zacks Investment Management, we use research to drive all of our decisions, and we’re actively managing portfolios to ensure every stock is generating strong cash flows, maintaining solid gross profit margins (particularly in an inflationary environment), and delivering better-than-expected earnings consistently. I think this analysis will be even more crucial in 2022, with earnings growth rates coming back to Earth as seen in the chart below.

Zacks Investment Research3

In the past 10 years or so, capital has rotated quite a bit away from the value and small-cap stocks and towards growth and large-caps, generally speaking. Much of the growth surge happened because of technology’s continued rise, which accelerated greatly during the pandemic. Each of the five stocks I mentioned at the start of this column is riding that wave.

I think the question from here becomes whether capital – particularly in a rising interest rate environment – starts to rotate into other areas of the market that are now trading at a discount. The S&P 600 (an index of small-cap stocks), for example, currently trades at about 15x forward earnings, which makes small-cap stocks about 30% cheaper than their large-cap counterparts. Mid- and large-cap value stocks also look increasingly attractive on a relative basis.4

2022 may be set up as a year where some of the market’s concentration in high valuation stocks and a limited set of names gives way to capital rotation into undervalued companies that still generate strong earnings and cash flow. For investors, I think that means stock selection and active management – which is our focus at Zacks Investment Management – will be key in 2022.

Bottom Line for Investors

For all the earnings and growth volatility generated by the pandemic over the last two years, the U.S. stock market has charged ahead. In 2021, equity investors who stayed the course likely experienced above-average returns with below-average volatility – certainly not what you might expect in a year as bizarre as that one.

I do not think the stock market is poised to do poorly in 2022 or that the risk of recession is high. But because earnings growth faces tough comparisons – and because the Federal Reserve will be tightening monetary policy throughout the year – I think careful stock selection will be a priority. Our research-driven process and disciplined approach should serve us well.

Disclosure

1 Washington Post. January 3, 2022. https://www.washingtonpost.com/business/the-stock-market-is-too-narrowly-focused/2022/01/03/e6648a12-6c95-11ec-b1e2-0539da8f4451_story.html

2 Bloomberg Data. January 10, 2022.

3 Zacks. January 5, 2022. https://www.zacks.com/commentary/1848033/handicapping-the-q4-earnings-season

4 Seeking Alpha. January 6, 2022. https://seekingalpha.com/article/4478296-while-growth-collapses-look-here-for-undervalued-stocks-which-will-continue-to-thrive-in-2022

DISCLOSURE

Past performance is no guarantee of future results. Inherent in any investment is the potential for loss.

Zacks Investment Management, Inc. is a wholly-owned subsidiary of Zacks Investment Research. Zacks Investment Management is an independent Registered Investment Advisory firm and acts as an investment manager for individuals and institutions. Zacks Investment Research is a provider of earnings data and other financial data to institutions and to individuals.

This material is being provided for informational purposes only and nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. Do not act or rely upon the information and advice given in this publication without seeking the services of competent and professional legal, tax, or accounting counsel. Publication and distribution of this article is not intended to create, and the information contained herein does not constitute, an attorney-client relationship. No recommendation or advice is being given as to whether any investment or strategy is suitable for a particular investor. It should not be assumed that any investments in securities, companies, sectors or markets identified and described were or will be profitable. All information is current as of the date of herein and is subject to change without notice. Any views or opinions expressed may not reflect those of the firm as a whole.

Any projections, targets, or estimates in this report are forward looking statements and are based on the firm’s research, analysis, and assumptions. Due to rapidly changing market conditions and the complexity of investment decisions, supplemental information and other sources may be required to make informed investment decisions based on your individual investment objectives and suitability specifications. All expressions of opinions are subject to change without notice. Clients should seek financial advice regarding the appropriateness of investing in any security or investment strategy discussed in this presentation.

Certain economic and market information contained herein has been obtained from published sources prepared by other parties. Zacks Investment Management does not assume any responsibility for the accuracy or completeness of such information. Further, no third party has assumed responsibility for independently verifying the information contained herein and accordingly no such persons make any representations with respect to the accuracy, completeness or reasonableness of the information provided herein. Unless otherwise indicated, market analysis and conclusions are based upon opinions or assumptions that Zacks Investment Management considers to be reasonable. Any investment inherently involves a high degree of risk, beyond any specific risks discussed herein.

The S&P 500 Index is a well-known, unmanaged index of the prices of 500 large-company common stocks, mainly blue-chip stocks, selected by Standard & Poor’s. The S&P 500 Index assumes reinvestment of dividends but does not reflect advisory fees. The volatility of the benchmark may be materially different from the individual performance obtained by a specific investor. An investor cannot invest directly in an index.

The Russell 1000 Growth Index is a well-known, unmanaged index of the prices of 1000 large-company growth common stocks selected by Russell. The Russell 1000 Growth Index assumes reinvestment of dividends but does not reflect advisory fees. An investor cannot invest directly in an index. The volatility of the benchmark may be materially different from the individual performance obtained by a specific investor.

Nasdaq Composite Index is the market capitalization-weighted index of over 3,300 common equities listed on the Nasdaq stock exchange. The types of securities in the index include American depositary receipts, common stocks, real estate investment trusts (REITs) and tracking stocks, as well as limited partnership interests. The index includes all Nasdaq-listed stocks that are not derivatives, preferred shares, funds, exchange-traded funds (ETFs) or debenture securities. An investor cannot invest directly in an index. The volatility of the benchmark may be materially different from the individual performance obtained by a specific investor.

The Dow Jones Industrial Average measures the daily stock market movements of 30 U.S. publicly-traded companies listed on the NASDAQ or the New York Stock Exchange (NYSE). The 30 publicly-owned companies are considered leaders in the United States economy. An investor cannot directly invest in an index. The volatility of the benchmark may be materially different from the individual performance obtained by a specific investor.
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