Stock market concentration has increased dramatically in recent years at the market, sector, and stock level. However there are ways investors can diversify their portfolios while maintaining exposure to market leaders, according to Goldman Sachs Research.
“Market dominance is not unprecedented and is only a problem if it is not supported by fundamentals,” Peter Oppenheimer, chief global equity strategist and head of Macro Research in Europe for Goldman Sachs Research, writes in the team’s report. “That said, at the stock level in particular, dominant companies rarely stay the best performers over long periods of time.” (Listen to the Goldman Sachs Exchanges podcast on rising stock market concentration.)
Why is the US stock market so strong?
The US stock market has consistently been the world’s biggest over the past 50 years, but its share has been steadily climbing in the aftermath of the global financial crisis (GFC). It now captures around 45% of the global equity market, compared with about 30% in 2009.
The longer-term rise in the relative size of the US equity market has reflected the strength of the US economy, but its dominance has accelerated dramatically since the GFC, outstripping increases in market capitalization in Asia and Europe. Relative to GDP, the US share of equity market capitalization has risen steadily as well, though part of this reflects the fact that many non-US companies are now in the US stock market.
The stellar earnings growth of US companies over this time further explains their relative outperformance, Oppenheimer writes. Both share prices and earnings per share have consistently declined for non-US companies relative to their US-listed counterparts. In addition, the US stock market has more exposure to faster growing industries than the rest of the world, the reinvestment rate of companies in the US stock market is higher than in most other markets, and it enjoys greater liquidity that helps reduce the risk premium.
“The US economy is bigger and stronger than others and the growing trend towards US listings by foreign-based companies has added to this effect,” Oppenheimer writes.
While the US equity market has become increasingly expensive relative to the rest of the world, the premium being placed on US stocks is justified by superior rates of return, and the US valuation premium isn’t extreme when adjusting for its higher level of profitability and returns on equity, according to Goldman Sachs Research. Furthermore, diversifying outside the US isn’t always straightforward — other markets may be correlated with the US.
That said, “there are many quality growth companies” in other regions, and they should be considered as part of a diverse portfolio, Oppenheimer writes. The report cites Japan as a potentially attractive market among developed markets, and our analysts say there may be opportunities in India (notably growth stocks) and China (value stocks).
Goldman Sachs Research also recommends an overweight allocation to Europe’s consumer-cyclical stocks — companies whose performance is closely linked to the state of the economy and the business cycle — as the region’s activity rebounds (European consumers have high savings and real wage growth).
Tech sector domination could continue
Another source of increasing market concentration is among sectors, as technology, media, and telecom stocks have continued to capture a rising share of the global stock market, particularly in the US but also in other markets such as Asia.
While global technology profits have surged since the GFC, other sectors in aggregate have made “virtually no progress,” Oppenheimer notes. This dynamic was exacerbated by the pandemic, which enforced social distancing and drove demand for technology relative to other parts of the economy.
“While the rise in interest rates over the past couple of years dented the relative earnings growth of the technology sector, its superior growth rate has resumed over the past year,” Oppenheimer writes. Tech firms’ significant cash piles have given them a further advantage from the recent rise in interest rates, as they have reinvested their cash at a very high rate.
The level of tech concentration is not unprecedented among dominant sectors in the past, according to Goldman Sachs Research. The current tech sector is about the same size as the energy sector was at its height in the mid-1950s, for example, and it remains smaller than both transportation (which dominated in the 20th century) and finance and real estate (which drove the stock market in the 19th century).
“Over the past 200 years, the biggest industry represented in the stock market at each point in time has reflected the major driver of economic growth,” Oppenheimer writes.
While our researchers recommend overweight allocations to technology stocks in all regions, they see good opportunities for investors to hedge technology dominance by diversifying tech exposure with selected fast growing, or “growth” stocks, that are cheaper. There may be opportunities in healthcare in all regions except Japan, due to a combination of attractive valuations and high growth prospects, Oppenheimer writes. Likewise European GRANOLAS — 11 of the largest companies in the STOXX 600 — as a group is relatively cheaper than their Magnificent Seven counterparts in the US. These European stocks have similarly strong balance sheets, high profits, and high and stable margins, according to the report.
To diversify further among sectors, investors can increase exposure to “ex tech compounders” — the term the team uses for companies that have market capitalizations above $10 billion and share certain key factors. These include high margins, high profitability, strong balance sheets, low volatility, strong growth prospects, and a decade’s worth of consistent earnings growth behind them.
Finally, quality growth stocks can be complemented with some value stocks — companies that trade at relatively cheap valuations compared to their growth and earnings potential. Some examples of these equities include energy and financials in the US, and consumer cyclicals in Europe, according to Goldman Sachs Research.
Can the Magnificent Seven hold on?
Oppenheimer and his colleagues also take a look at the investment implications of a small handful of companies dominating the stock market. Separate analysis by Goldman Sachs Research finds that the US stock market has often rallied after bouts of high concentration. Oppenheimer and his team find similar patterns of high concentration in other markets, including Europe (the group of GRANOLAS stocks account for nearly one quarter of the value of the 600 biggest companies).
“While high stock market concentration may be a sign of a bubble, it does not necessarily mean there is one,” Oppenheimer writes. High stock concentration isn’t unusual, and many of the dominant companies of late have high profits and strong balance sheets.
Even so, today’s dominant companies are far from assured of having such a high share of market capitalization further down the line. Only 52 companies have appeared every year in the Fortune 500 since 1955, according to Goldman Sachs Research, and it predicts that almost all of today’s top companies will be missing from the list when it’s released 70 years from now.
“Historically, with new entrants emerging, few companies remain unscathed as competition either forces companies to disappear, merge, or be acquired,” the authors write. “From this perspective, a market that becomes dominated by a few stocks becomes increasingly vulnerable to either disruption or anti-trust regulation.”
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