- The top 10 U.S. mega-caps now make up c.30% and c.20% of the S&P 500 and MSCI World index by market cap weight respectively.
- The ‘magnificent seven’ – Apple (AAPL), Microsoft (MSFT), Amazon (AMZN), Nvidia (NVDA), Tesla (TSLA), Alphabet (GOOG) and Meta (META) – returned 60% over the first half of 2023 [Figure 1], which helped propel the Nasdaq to a gain of 39%, the best first half of any year on record.
- Only one-third of U.S. shares have outperformed the S&P 500 over the first half of 2023, the worst first six-month breadth on record for U.S. equities.
- Highly concentrated returns, large index weight and high average valuations (P/E ratio of 28x) of these mega-caps increases risk for investors and may leave passive funds vulnerable to potential losses if interest rates do not return to prior decade lows and optimistic earnings expectations do not materialise.
Technology remains the most popular trade
Global investors have flocked to the U.S. mega-cap technology and consumer stocks over the past few months on expectations that inflation and interest rates have peaked and will swiftly revert to prior decade lows, driving their rich valuations even higher. Earnings growth expectations have risen sharply, fuelled by AI excitement, cost-cutting, and shallow-recession narratives driving people to believe that earnings will recover in the second half of the year and accelerate into 2024.
Apple became the first company ever to reach $3.0 trillion in market capitalisation, making it more highly valued than the entire UK stock market. Meanwhile Nvidia’s market capitalisation rose from $250 billion to over $1.0 trillion while Tesla is up 124% this year, now valued at $874 billion. The seven mega-caps with a combined market capitalisation of $12 trillion have returned 60% this year, driving the S&P 500 market cap weighted index up 16% to substantially outperform its “equal weight” counterpart, which is only up 6% [Figure 1].
History teaches us that this is a time for caution
While many market participants seem to subscribe to the view that “this time it’s different”, we believe there are several reasons to be cautious with following the popular trade.
- Today’s rich valuations and lofty expectations for these seven U.S. mega-cap stocks leave little room for earnings or interest rate disappointment. If inflation does not fall back to the Fed’s 2% target, policy rates will remain higher and long bond yields will rise sharply, which is disastrous for richly valued valuation multiples.
- The concentration risk within the S&P 500 index today means that investors are increasingly betting on the fortunes of just a handful of companies, whose average P/E ratio is 31x on a market capitalisation weighted basis.
- Prior periods of peak concentration – such as the 1999/2000 tech bubble, 2007/08 housing and financial bubble and 2020/21 post-Covid bubble – ended badly for the most highly valued market leaders resulting in the market cap weighted S&P 500 underperforming the broader equal weighted index [Figure 2].
- After 15 years of outperformance, U.S. stocks now make up nearly 70% of the MSCI World index and this significantly increased concentration risk for global investors in the mostly highly valued U.S. mega-cap growth stocks.
- However, non-U.S. stocks trade on more reasonable P/E ratios of 12 to 13 compared to 21 to 23 for U.S.stocks. We believe this is even more appealing if we consider that Europe is at the bottom of the economic cycle while Asia Pacific is in the early recovery part of the cycle. Conversely, the U.S. is experiencing slowing growth and moving into its late cycle phase.
Be careful out there and opt for safer, less popular places to hide
In the first half of 2023, the S&P 500 and MSCI World indices have been driven by just a handful of U.S. mega-cap companies trading on lofty valuation multiples and optimistic earnings growth expectations, supported bythe narrative of cost cutting, a U.S. soft-landing and the transformative potential of AI.
However, the over-concentration of these mega-caps combined with the overvalued U.S. dollar and 15-yearoutperformance of U.S stocks, meaningfully increases the concentration risk in global benchmarks such as theS&P 500 and MSCI World index. Prior periods of peak concentration (1999/2000, 2007/08, 2020/21) havetypically ended poorly for the favoured market leaders.
We believe investors should consider non-U.S. stocks which have higher risk-adjusted expected returns than U.S.stocks, given lower starting valuations and lower levels of earnings when compared to their U.S. counterparts.
With only 33% of U.S. and 45% of European stocks outperforming their benchmark indices thisyear, market breadth has been incredibly narrow. We believe this provides fertile ground for stockpickers such as ourselves to generate above-average returns as the economic and market cycleinflects over the next few years