The dominance of a narrow group of stocks in the market is not unprecedented and is only a problem if it is not supported by fundamentals. Nevertheless, a narrow group of dominant companies rarely remains the most efficient in the long term.
Dominance of US stocks
The US stock market has consistently been the largest in the world for the past 50 years, and its share has steadily risen since the global financial crisis. This was helped by the relaxed monetary policy, which created a suitable environment for investment. Now the US market occupies about 45 percent of the world stock market, while in 2009 it was about 30 percent.
In the years around the so-called dot.com bubble, the American markets had roughly a 50% share of the world stock market, then also a narrow group led the markets up. However, this period cannot be directly compared with the present, as today’s growth in the valuation of large technology companies is supported by real growth in economic results.
This growing share of the relative size of the world stock market reflects the strength of the US economy. The dominance of US stocks has accelerated dramatically since the Great Financial Crisis of 2008, outstripping market capitalization gains in Asia and Europe.
Relative to gross domestic product (GDP), the U.S. share of stock market capitalization has also steadily increased, although this partly reflects the fact that there are now many non-U.S. companies in the U.S. stock market. The significant growth in profits of American companies during this period explains their relative performance.
Both stock prices and earnings per share for non-US companies have consistently declined relative to their US-listed counterparts. In addition, the U.S. stock market has more exposure to faster-growing industries than the rest of the world, the reinvestment rate of companies in the U.S. stock market is higher than most other markets, and it enjoys greater liquidity, which helps reduce the risk premium.
The American economy is bigger and stronger than others, and the growing trend of listing American companies based abroad also contributes to this effect.
According to research by Goldman Sachs, the US stock market is still more expensive compared to the rest of the world, but the premium at which US stocks are traded is justified by higher rates of return. Taking into account the higher level of profitability and return on equity, the US valuation premium is said to be not extreme.
Additionally, diversifying outside the US is not always easy – other markets can be correlated with the US. Still, there are many quality growth companies in other regions and they should be considered as part of a diversified portfolio. The report lists Japan as a potentially attractive market among developed markets, and there may be opportunities in India as well (especially growth stocks, author’s note) and China (value stocks).
The research also highlights European consumer stocks, i.e. companies whose performance is closely linked to the state of the economy and the business cycle, as activity in the region picks up (European consumers have high savings and real wage growth).
The technology sector may continue to dominate
Stock market concentration is also growing from a sectoral perspective, as shares of technology, media and telecommunications companies continue to gain a growing share of the global stock market, especially in the US, but also in other markets, for example in Asia.
While tech company profits have soared since 2008, other sectors have made little to no progress overall. This dynamic has been exacerbated by the pandemic, which has forced social isolation and increased demand for technology relative to other parts of the economy.
While rising interest rates in recent years have reduced relative growth in the technology sector’s earnings, its growth rate has resumed in the past year. Tech firms’ substantial cash hoards have given them an added advantage, as they can earn interest on that cash at a high rate of interest. Level of concentration of technology firms (albeit high) is not historically extreme.
The current technology sector has about a 40% share of the total stock market. In short, a high concentration of an industry reflects that a given sector is the main driver of economic growth at a given time. While Goldman Sachs analysts recommend an increased allocation to tech stocks across all regions, they also see value in hedging against this tech dominance.
For example, by diversifying into growth (usually smaller) companies that are now cheaper due to increased rates. There are also opportunities in healthcare in all regions except Japan, thanks to a combination of attractive valuations and strong growth prospects.
Diversification can also be achieved to some extent by investing in the 11 largest European companies (so called Granolas), this group has more conservative valuations than their American counterparts from the “Magnificent Seven” group. Additionally, these European stocks have similarly strong balance sheets, high earnings, and high and stable margins.
For further sector diversification, investors can increase exposure to a group of stocks called “ex tech compounders.” This term is used by Goldman Sachs for companies that have a market capitalization of more than ten billion dollars and share certain key factors. These include high margins, high profitability, strong balance sheets, low volatility, strong growth prospects and a decade of consistent earnings growth.
Finally, quality growth stocks can be complemented with some value stocks – companies that trade at relatively low valuations relative to their growth and earnings potential. For example, these are energy and financial companies in the US and consumer cyclical companies in Europe.
Magnificent Seven
Since the beginning of last year, the stock market has been dominated by a small handful of companies. The analysis found that the US stock market has historically often risen after a period of high concentration. This concentration now also prevails in the European stock markets (the Granolas share group represents almost a quarter of the value of the 600 largest European companies).
High stock market concentration is not necessarily a symptom of a valuation bubble. High concentration of stocks is not unusual, and many of the dominant companies of recent times have high earnings and strong balance sheets. Nevertheless, today’s dominant companies are far from certain that they will continue to have such a high share of market capitalization.
Historically, as new players enter the market, few companies survive unscathed, as competition either forces them out of business, merges, or is taken over. From this perspective, a market that comes to be dominated by a few stocks becomes increasingly vulnerable to either competition or antitrust regulation.
The author is an analyst at BH Securities
(Editorially modified)
Tags: Diversification times concentrated stock markets Goldman Sachs research FAEI .cz
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