Investment Strategy Brief:
The Risks of a Concentrated Market

Below is a transcript of this week’s video.

Hi, this is Mike Reynolds with Investment Strategy at Glenmede.

Now halfway through the year, risk assets have so far seemed able to shrug off an aggressive Fed tightening cycle and elevated recession risks. Large cap stocks led the way in the second quarter, up almost 7%. In comparison, their smaller cap and foreign counterparts also posted smaller positive gains in Q2. On the flip side, investment-grade fixed income was a bit more of a mixed bag. In taxable bonds, rising rates led to price declines that more than offset the income received for negative total returns, though municipal bonds were able to eke out a small positive return. Seeing what we have so far to start 2023, how is this setting up how investors should approach the back half of the year?

The rally seen year-to-date has been unique, for the fact that it has been an increasingly narrow set of stocks driving the headline results so far. The top seven companies by market cap in the U.S., which are Apple, Microsoft, Alphabet, Amazon, Nvidia, Meta and Tesla, are each up more than 30% so far this year. Since they’re combined such a large part of the S&P 500, they’ve been a key reason why the index is up almost double digits this year. However, if one were to exclude the impact of these mega cap stocks, the S&P 500 would have posted a much more modest 1.3% return so far this year.

Not only has this been a concentrated market rally, by some measures it has been one the most narrowly-driven environments ever seen. For example, only a little more than 20% of constituents in the S&P 500 are outperforming the broader index over the last three-month period. This marks a historic low since at least 1990, even eclipsing the previous high around the frenzy for internet stocks at the peak of the Tech Bubble in the late ‘90s. There just has not been broad participation this year, suggesting the market’s reassessment of only a select few companies could see this rally fizzle out.

Part of that reassessment may be revisiting the valuation premium commanded by these top stocks. The largest five companies in the S&P now trade at almost double the forward-looking price-to-earnings ratios of the rest of the index. While this is not the most extreme these valuation disparities have been in the past, it would be difficult to call this occurrence normal from a historical perspective. But since these companies represent such a large portion of the passive index, proper diversification now must become a proactive exercise in light of this increased concentration and excess valuations.

Zooming out for a broader perspective, it’s clear that not all flavors of equities are valued similarly at this point in time. Large domestic growth stocks look far from cheap, sitting just below the 90th percentile of fair value. In contrast, large value, small cap, and international equities appear far more fairly valued at this point in time. This implies that tilting away from the most expensive parts of the equity market may be in the best interests of investors seeking longer-term value opportunities.

History tells us of the dangers of chasing recent winners in equity markets. The lesson here, is that this top-heavy market is unlikely to be sustainable over the long-term. For example, only one of the top five companies at the turn of the millennium (which were Microsoft, General Electric, Cisco, Walmart and ExxonMobil) remains there today, as increased competition and regulatory pressures usually lead to a churn among the largest firms. When broad indices appear increasingly concentrated as they do today, investors should take an active approach to diversifying their investments consistent with a longer-term valuation discipline.

So to summarize, stocks posted solid gains in Q2, but it was not a broad-based rally by any means. A broad index like the S&P 500 is meant to represent a diversified approach to investing, but it has looked less so lately as leadership has narrowed significantly this year. The mega cap drivers of this market command significant valuation premiums relative to the broader large cap universe, as well as their smaller and foreign counterparts. Just because a company is on top now does not guarantee their place there forever, especially as they become targets for regulatory and competitive scrutiny. In this type of environment, investors should be focused on actively diversifying their portfolios, especially in a market that’s appearing increasingly concentrated and expensive.

Thanks for listening! And please don’t hesitate to reach out with any questions.

This material is intended to review matters of possible interest to Glenmede Trust Company clients and friends and is not intended as personalized investment advice. When provided to a client, advice is based on the client’s unique circumstances and may differ substantially from any general recommendations, suggestions or other considerations included in this material. Any opinions, recommendations, expectations or projections herein are based on information available at the time of publication and may change thereafter. Information obtained from third-party sources is assumed to be reliable but may not be independently verified, and the accuracy thereof is not guaranteed. Outcomes (including performance) may differ materially from any expectations and projections noted herein due to various risks and uncertainties. Any reference to risk management or risk control does not imply that risk can be eliminated. All investments have risk. Clients are encouraged to discuss any matter discussed herein with their Glenmede representative.