S&P 500’s Largest Companies Face Potential Market-Beating Setback
The asset allocation team at Jeremy Grantham’s GMO has warned that the largest companies in the S&P 500 may not be able to sustain their outperformance in the long run. According to data from 1957-2023, the nine out of ten largest stocks in the index underperformed on average in the year following their ranking. This trend is attributed to the fact that these stocks tend to become expensive and have historically exhibited poor relative returns. In fact, since 1957, the 10 largest stocks in the S&P 500 have underperformed the remaining 490 stocks by 2.4% per year.
Concentration in the S&P 500 Increases, Raises Concerns
GMO reports that the S&P 500 has become significantly more concentrated, with the top seven companies now accounting for 28% of the index, up from 13% a decade ago. These companies, collectively referred to as the Magnificent Seven, include well-known tech giants such as Apple, Microsoft, Google parent Alphabet, Amazon, Nvidia, Facebook parent Meta Platforms, and Tesla. Their exceptional returns in 2023 contributed to their outperformance. However, GMO cautions against biasing portfolios towards these large stocks, as it has proven to be a disaster in the past.
The Magnificent Seven’s Pioneering Success
The Magnificent Seven had an impressive run, outperforming the S&P 500 by a staggering 60% in 2023. This exceptional performance was driven by factors such as their initial cheapness and their ability to reinvent themselves or dominate their respective industries. Microsoft and Amazon, for example, managed to grow their earnings through reinvention, while Apple, Alphabet, Meta, Nvidia, and Tesla emerged as leaders in their primary industries.
A Historical Perspective on Large-Cap Stocks
However, when analyzed over a longer time frame from 1957-2023, the largest 10 companies in the S&P 500 fell behind the average performance of the index. GMO’s quarterly letter presents a chart showing that these large-cap stocks generally trailed the average S&P 500 stock. This suggests that their current outperformance may not be sustainable in the long term.
Limited Outperformance in 2024
In 2024, the S&P 500 index has gained 4.8% so far, while only four stocks among the Magnificent Seven – Nvidia, Meta, Amazon, and Microsoft – are beating the index. This indicates that the mega-cap stocks may be facing a potential market-beating setback this year.
Unprecedented Decline in Diversification Raises Concerns
GMO expresses concern over the decline in diversification within the S&P 500. Comparing the index to ten years ago, they note that it was more than twice as diversified. This decline in diversification, along with the increasing concentration of the largest companies, poses potential risks to the overall health and stability of the index.
Analyst comment
Heading 1: Negative news. Analyst: Market may see a setback as the largest companies in the S&P 500 are expected to underperform in the long run due to high valuation and historical poor returns.
Heading 2: Negative news. Analyst: Concentration in the S&P 500 raises concerns, portfolios should not be biased towards large stocks as it has proven disastrous in the past.
Heading 3: Positive news. Analyst: The Magnificent Seven had a successful year, outperforming the S&P 500, driven by factors like innovation and industry leadership.
Heading 4: Negative news. Analyst: Historical analysis shows that large-cap stocks have generally underperformed the S&P 500, suggesting current outperformance may not be sustainable.
Heading 5: Negative news. Analyst: Mega-cap stocks may face a market-beating setback in 2024 as most are underperforming the index.
Heading 6: Negative news. Analyst: Decline in diversification and increasing concentration of largest companies pose potential risks to the overall health and stability of the index.
