Dominance of Mega Caps Highest In Decades

Global stock market concentration is at the highest levels in decades increasing risk for passive investors. After years of impressive gains, the “Magnificent 7” stocks today represent 30% of the S&P 500 Index’s market capitalization.

These stocks have historically seen the most trading volumes, but at the current moment, the massive positions held in benchmark equity indices that many passive investors prefer to use, as well as the high correlations the stocks have in terms of industry and field, are putting passive investors at risk.

What's Wrong?

Typically investing in benchmark ETFs and mutual funds is the standard when looking to diversify exposure to the stock market and oftentimes model the S&P 500, gaining moderately without the excess risk.

Well what if one was to tell you that the S&P 500 isn’t as diversified as you thought?

That's right, currently there are seven stocks known as the ‘Magnificent Seven’ that are dominating the market. 

These stocks are:

• Microsoft (NASDAQ: MSFT)

• Apple (NASDAQ: AAPL)

• Nvidia (NASDAQ: NVDA)

• Amazon (NASDAQ: AMZN)

• Alphabet (NASDAQ: GOOGL, GOOG)

• Meta Platforms (NASDAQ: META)

• Tesla (NASDAQ: TSLA)

If these seven stocks were to revert back to their Dec 2020 valuations, well, the market caps would drop by about a third spiraling the S&P 500 down by 9%. 

These seven stocks control over 30% of the index’s total market capitalization which is at a historically high level not seen before in financial history. 

How Did This Happen?

Answer: Ultra-low interest rates in the last 15 years, and the recent enthusiasm of artificial intelligence (AI). 

The Mag 7 has accounted for nearly two-thirds of the index’s returns. 

While there may be some more room for these high-flying mega caps to rise further, their outsized position in the benchmark index creates huge risks for investors in the event of a market pullback or major decrease in any one of those stocks. 

Should even one tumble it could lead a considerable blow to even the most risk averse investor portfolios, solely because of the stocks massive position in the index. 

Technology Correlation

This is especially compounded by the fact that these seven stocks are highly correlated, all originating in the technology sector. If the technology sector as a whole experiences a pullback or correction then all seven stocks will feel it in some way or another bringing down the entire index.

In addition, the returns of these seven stocks were heavily driven by investor enthusiasm related to AI and machine learning (ML). With these overlaps in business lines, if investors pullback from AI or even one stock receives unsavory news, the entire group of stocks can also fall, dragging down the value of more stocks within the S&P 500 with it.

Interest Rate Sensitivity

During Covid and even pre pandemic, interest rates were low. This was favorable to massive corporations as it not only stimulated the economy but also allowed for the companies to borrow money for ventures more freely and much cheaper than otherwise. 

Well now times have changed and it is 2024, interest rates have been rising and with it the sensitivity of stock valuations. Unlike value stocks, technology stocks are heavily expounded by the prediction of future returns. Due to the rise in interest rates, it is now harder for these conglomerates to borrow money, which in turn, can cause stresses to the future financials of the Mag 7.

Currently these stocks are extremely pricey, sporting a P/E ratio of about 28 compared to the average S&P 500’s multiple of around 20. If high interest rates decide to stick around, these valuations may decrease leading to major damage to the S&P 500 as the market corrects itself.

What to do?

To reduce risk, investors should consider adding more exposure to their portfolio by investing into U.S Bonds and other non-U.S equities like fixed incomes and alternative assets. This will allow passive investors to build out true diversification and have investments that hedge against a potential drop in the Mag 7.