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With volatility returning to markets over the summer, a renewed sense of uncertainty reemerged. There has been much discussion centered around the mega-tech stocks, with some suggesting their relative concentration and lofty valuations pose risks to future equity market gains. Here are some perspectives:
1. Market concentration is the norm, not the exception. A look over time at the S&P 500 shows that concentration is more common than we think. In the 1950s and 60s, the top 10 stocks regularly made up about one-third of total market capitalization. This jumped to more than 40 percent in the 1970s, during the time of the ‘Nifty Fifty’ stocks. Though the concentration of the top 10 stocks fell below 20 percent in the 1980s, it rose to almost 30 percent by the early 2000s.1
In fact, this concentration is not limited to the U.S. markets. With the G7, most countries are far more concentrated than the U.S. (graph below). Canada’s top 10 holdings make up around 43 percent of the total index, as measured by the MSCI country stock market ETFs.2
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Of course, given the tech sector’s concentration in U.S. markets, it is a reminder that no sector is impervious to downturns — just one reason to highlight the importance of diversification within a portfolio.
2. Multiple expansion is not at historical highs. While valuations have increased over the long term, often measured by the CAPE ratio,* multiple expansion may play a smaller role than most people assume. This is supported by work done by the late renowned investor John Bogle, who used the following formula to estimate expected returns:
Expected stock market returns = Dividend Yield + Earnings Growth +/- Change in Price/Earnings (P/E) Ratio
Financial strategist Ben Carlson recently updated Bogle’s S&P 500 return data by decade (chart) to observe what may be driving returns. The P/E change — or multiple expansion/contraction — may be viewed as a gauge of investor sentiment or emotions, or what people are willing to pay for earnings. While there has been multiple expansion in the 2010s and 2020s, it isn’t quite as significant as that of the 1980s and 1990s. Earnings growth has been the main driver of stock market returns since the Global Financial Crisis. One likely reason is efficiency and productivity gains from advances in technology.
https://awealthofcommonsense.com/2024/02/whats-driving-the-stock-market-returns/based on “Don’t Count On It!” John Bogle.
Keep in mind that these observations are not pertinent to short-term market movements. However, they do show that, over the longer term, fundamentals like corporate earnings have been a key driver of stock market returns. Over time, the underlying growth trend in equities has generally mirrored the growth in corporate profits and the economies in which these companies participate. Of course, there can be substantial swings around the trendline based on investor behaviour — consider periods of euphoria and fear, when stock prices get ahead of themselves or fall to levels at bargain prices.
This may be good investing food for thought: The human condition to advance, progress and grow is unwavering and is likely to drive corporate profits into the future. Investors, should we choose to participate, can share meaningfully in the growth yet to come.
1. https://awealthofcommonsense.com/2024/02/is-the-u-s-stock-market-too-concentrated/;
2. Using MSCI country stock market ETFs as the means of measurement.
* The CAPE ratio or Shiller Price Earnings ratio is a valuation measure that uses real earnings per share (EPS) over a 10-year period to smooth out fluctuations in corporate profits that occur over different periods of a business cycle.
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