Most investors are not aware that just seven companies have kept the S&P 500 Index afloat this year. Apple, Meta, Microsoft, NVIDIA, Amazon, Alphabet, and Tesla have driven the vast majority of gains.
The concept of “market breadth” analyzes how stocks perform relative to one another in a given index, such as the S&P 500. Positive market breadth occurs when more stocks are advancing than declining.
Conversely, negative market breadth (which I am describing as “bad breadth”) means more stocks in the index are down versus up. Sometimes, the index is rising even though more than half of its constituents are falling!
In terms of index concentration, Apple and Microsoft stand out with weights of 7.7% and 6.8%, respectively, as of 6-30-2023. This is more than double that of Alphabet, the third-largest holding, at 3.6%. This dynamic is self-reinforcing. Higher stock prices can fuel market capitalization gains and index recalculations, which in turn fuel additional inflows to these stocks as millions of investors in passive funds make their regular contributions under defined contribution plans, perpetuating the cycle.
Outsized impact of the “Magnificent Seven” stocks to returns
Another useful way to look at the increasing narrowness of the US equity market is through a measure that antitrust regulators use to gauge market concentration within an industry, the Herfindahl-Hirschman Index (HHI). The index allows us to answer the following hypothetical: Let’s say you wanted to create an equally weighted portfolio of stocks that would provide the same level of diversification as the market-cap weighted S&P 500 Index.
How many stocks would there be in that hypothetical portfolio? This number is called the “effective number of constituents” (ENC) in an index, an inverse of the HHI. The answer is 60 stocks (as of June 30, 2023).
Because the S&P 500 Index is so highly concentrated, it doesn’t provide any more diversification than a portfolio of 60 equally weighted stocks, according to the HHI measure.
The effective number of constituents in the S&P 500 Index
If it weren’t enough that the diversification power of the equity portion of many investor portfolios had eroded, the diversification typically achieved with a bond allocation is somewhat diminished as well. Since December 2012, over rolling 90-day periods, higher market concentration was associated with higher correlations between stocks and bonds. That is, stocks and bonds tended to move more in unison. As a result, the overall diversification benefit of a typical mixed asset portfolio was reduced on the margin.
As a result, should markets turn lower, investors could be hit with a less diversified equity investment.
Narrow markets reduce diversification potential
To be clear, the situation is far from dire. And there is some evidence that narrow market rallies have often been followed by steady gains for the broader market. However, investors must consider that should euphoria over AI subside, a pullback in tech stocks could stifle a broader rally. As of the end of Q2, nearly all 11 sectors in the S&P 500 generated positive results for the quarter to date. However, the price-to-earnings ratio for the S&P 500 technology sector was 27.1 times earnings (again as of 6-30-2023), compared with 18.9 times earnings for the broader S&P 500.