I Get Why Having 3 Stocks Make up 20% of the S&P 500 Might Scare You

But the stock market does better when concentration is rising

Owning the largest company has historically been a very bad investment. Once you reach the top of the mountain, you have nowhere to go but down.

In a new paper about concentration and what it means for the market, Michael Mauboussin and Dan Callahan showed that “the arithmetic average of the series of annual returns of the top stock relative to the S&P 500 from 1950 to 2023 was -1.9 percent.”

Today’s tech giants are dominating the field like no company in history and have obliterated the thesis laid out above.

Apple has been the largest stock in the S&P 500 for 99.96% of the time since 2014. And over that time, it’s up 861%, almost four times better than the S&P 500. That’s 25.4% compounded annually for the last decade, compared with 12.6% for the S&P over the same time.

Only five companies have held the title of second largest company in the S&P 500 over the last ten years: Microsoft, Apple, Amazon, Google, and ExxonMobil. We can now add a sixth stock to that list, Nvidia. This week, for the first time ever, Jensen Huang’s creation crossed $3 trillion in market cap and passed Apple for second place. Absolute lunacy when you consider that Apple had a $2.35 trillion lead not even two years ago.

The big three, Microsoft, Apple, and Nvidia, now control $8 trillion in market cap, which is 15% of the U.S. stock market. We haven’t seen anything like this since the 1960s!

So here’s the question on every investor’s mind: Is concentration bad? Well, bad for who? For portfolio managers, it’s terrible. It’s hard to outperform the index when the largest stocks are leading, as you can clearly see in the chart below.

But since you’re probably not running a mutual fund, you’re more likely to be concerned about what concentration means for the market. It turns out that the stock market does better during periods of rising concentration.

But the last time! I know, last time things ended very badly.

According to Mauboussin/Callahan, the top 3 stocks at the end of 1999, Microsoft, General Electric, and Cisco, were trading at 65, 42, and 97 times forward earnings.

Today’s big three, Microsoft, Nvidia, and Apple, are trading at 36, 45, and 30 times forward, respectively. This doesn’t mean it can’t end badly, but simple comparisons to the last time are, in my opinion, not apples to apples.

We spoke about this and a lot more on this week’s TCAF with Eric Jackson and Alex Kantrowitz.