After a brief respite, the Magnificent 7 stocks have again hit new highs on the heels of Nvidia’s blowout earnings: They now again comprise about 30% of the S&P 500. Throw in the remainder of the top 10 stocks (Berkshire Hathaway, Lilly, and Broadcom) and the concentration rises to about 33% of the S&P 500.
At the recent ETF conference in Miami Beach, Registered investment advisors were eager for advice on how they might get their clients to stop pestering them to invest more money in the Magnificent 7.
There was much handwringing about the dangers of over-concentration. RIAs worried that just like they get blamed for not being in the Mag 7 rally with sufficient zest, they will get clobbered by clients blaming them when (and if) they bubble bursts.
The hope of the RIAs was the market rally would broaden out.
Fat chance. That was two weeks ago, during a brief lull in the relentless march of Nvidia and the Magnificent 7.
But Nvidia’s earnings have killed the last hope of the “diversify” crowd. The numbers speak for themselves:
Major Sectors YTD
Van Eck Semiconductor ETF (SMH) up 20% (25% Nvidia!)
Roundhill Magnificent 7 ETF (MAGS) up 14% (14% Nvidia!)
S&P 500 up 5% (4% Nvidia!)
S&P 500 Equal-Weight ETF (RSP) up 2%
Is over-concentration really a risk?
On the surface, it sure seems that way. The comparisons are getting silly.
At the ETF conference, Dimensional Fund Advisors noted that the Magnificent 7 stocks were now just as large as the entire combined stock markets of Japan, UK, Canada, France, Hong Kong/China combined:
Magnificent 7 vs. The World
(MSCI All Country World Index weighting)
Entire U.S. stock market: 63%
Japan, UK, Canada, France, Hong Kong/China combined: 17.5%
Magnificent 7: 17%
Source: Dimensional Funds
That seems crazy, no? And yet, it’s not at all unusual to see concentration like this in prior periods. And it’s mostly around tech.
High concentration levels have happened often
It’s true concentration has risen in the last 10 years. As late as 2015, the top 10 stocks in the S&P 500 were only 17.8% of the index, according to a 2023 study by FS Investments.
But that was a low point. Most of the time, the concentration of the top 10 stocks has been far higher.
For example, in the mid-1960s the concentration of the top 10 was over 40% of the S&P 500.
The domination of the so-called “Nifty 50” stocks (which included IBM, American Express, General Electric, Polaroid and Xerox) in the 1960s and early 1970s regularly kept the concentration of the top 10 stocks over 30%.
It slowly declined over the next 20 years, settling between roughly 17% and 20% of the market capitalization of the S&P 500 between the 1980s and the late 1990s.
It shot up again during the dotcom and Internet boom, which again pushed the concentration of the top 10 to over 25% in the late 1990s.
It’s not just a U.S. issue
Other countries like China, France, and Germany have far higher concentration in the top 10 names than the U.S.
The broadest China ETF, the iShares MSCI China ETF (MCHI) has over 600 stocks. But the top 10 stocks, which include Tencent, Alibaba and Baidu, comprise 42% of the entire ETF.
Same with Germany: The iShares MSCI Germany ETF (EWG) has 57% of its weighting in 10 stocks, with 22% in just two stocks, SAP and Siemens.
Same with the United Kingdom: The iShares MSCI UK (EWU) has 50% in the top 10 holdings, with nearly a quarter in three stocks, Shell, AstraZeneca, and HSBC.
Same with France: The iShares MSCI France (EWQ) has 57% in the top 10 with just two companies — LVMH and Total — comprising 20% of the weighting.
And same with Canada: The iShares S&P/TSX 60 Index (XIU) has 45% in the top 10 holdings.
Concentration of top 10 stocks in country indexes
China 42%
Germany 57%
UK: 50%
France: 57%
Canada 45%
U.S.: 33%
Concentration has helped U.S. and index investors
You may worry about it, but concentration has been a boon to index investors and to U.S. investors in general.
We all know the majority of the gains in the last year can be attributed to a small number of mostly tech stocks. Investors who own the S&P 500 don’t have to pick those winners; they just go along for the ride.
Second, U.S. stocks are global market leaders, and when a small group becomes market leaders it almost always means the U.S. stock market outperforms the world.
That is exactly what has happened. The U.S. stock market, which was roughly 40% of the global market capitalization a short while ago, is now roughly 50% of global market capitalization.
U.S. investors in broadly diversified indexes have been richly rewarded for their “concentration risk.”
Sit back and relax a little
Here’s what it all means: Concentration is a characteristic of market cap-weighted indexes. These indexes reward the winners and penalize the losers.
The reason the Magnificent 7 has done so well is that these are the most profitable companies in the world. They are at the cutting edge of transformative technologies, particularly AI.
That’s the primary reason they are the leaders. There are also secondary reasons: globalization, which made supply chains more efficient, and the long decline in interest rates (which has come to an end).
But the bottom line is that in an era where growth has been hard to come by, these companies have plenty of it. And investors are willing to pay up.
What about comparisons to the dot-com era? The stocks at the top contribute a far greater amount to the earnings of the S&P 500 than they did in the 1990s. And the cash flow is much higher.
There’s already been a correction: It was called 2022
At the ETF conference, the big worry among the RIAs was, “But what if there’s a big correction in the Magnificent 7?”
Uh, sorry, but they already corrected. Nvidia went from roughly $292 at the start of 2022 to $112 by October of that year, a drop of 62%. The other Magnificent 7 stocks all had big drops then.
Of course they could all correct again. But the AI revolution is very real.
Nvidia’s sales tripled. Profits were up 800%. That is a very real revolution.
