The USA has never seen such a large percentage of its share market represented by so few stocks. The booming share prices of the ‘Magnificent 7’ as they are called (Apple, Amazon, Alphabet, Meta, Microsoft, Nvidia and Netflix) has driven the market higher. But their disproportionate gains compared to the rest of the market means they now make up roughly 29% of the S&P500 index. If you are invested in a fund or ETF that replicates the S&P500 Index that’s the ratio your investment has. Basically 30% to 7 big tech companies and 70% to the next 493.
But does that translate into ‘bubble territory’ for the S&P500?
In ordinary times, it would be easy to for investors to assume that it is because at face value, it looks like a bubble given the rapid rise in share prices. However, the real answer is more complex. There are several nuanced layers to the recent surge in these 7 key stocks so it’s more difficult to quantify bubble territory than usual.
I am usually the last person to say ‘this time it’s different’ because inevitably it is not. A healthy dose of scepticism is a good way to stop yourself from getting caught up in the hype. However, at this very moment, it might be different for several reasons.
It is an unprecedented imbalance that has many investors comparing this situation to previous bubbles such as the dom.com boom and bust and more recently the tech crash following the rise and fall of crypto and the metaverse. The biggest difference here is what underpins the rapid rise.
Perhaps most significantly, these companies are at the forefront of capitalising on the early stages of the AI mega trend. This is not a fad; the AI surge is very real, and it is in my view going to be the most significant technological advancement in history.
AI is going to create huge revenue opportunities and importantly massive productivity gains across the world. In fact, it already is for many companies. As long as the revenue and earnings growth continue to meet expectations, you can justify higher share prices. It is even possible that markets are underestimating just how much and how quickly the exponential growth of AI will change everything in the world in the years ahead.
Secondly, these stocks are mainly online platforms with global distribution and scale unlike anything the world has seen. This is not hyperbole. The nature of technological globalisation is one that allows for access to customers more cheaply and quickly than any businesses have ever been able to.
The third aspect driving share prices higher is simply the weight of money being allocated to these stocks. These global behemoths are the types of businesses that are able to survive almost any economic or political conditions. So, a key element of that flow of money is effectively a flight to safety as investors look to protect capital in uncertain times.
In the past investors bought shares in ‘recession proof’ businesses like Coles and Woolworths or their international equivalent because the theory was people still had to eat. In today’s digital world it’s the tech companies that are essential to our everyday lives. The volatile geopolitical environment has influenced investors too. Similarly, rising global tensions creates uncertainty so investors look at ways to invest their funds so that their capital is protected.
Then there is the allocation through the massive passive funds management industry. These funds allocate capital to replicate exposure to the index. While that is generally a good thing, offering easy investment options it is not without its quirks, biases, or pitfalls. The simple weight of money pouring in gives no consideration to valuations. At a time where a sector is disproportionately weighted these index funds simply pour fuel on the valuation fire and make the bubble worse.
All of this is important context to understand when looking at the market. The recent performance of the S&P500 has been skewed by the performance of a handful of companies. For investors who are older or who have less aggressive risk profiles, exposure to the S&P500 is no longer the diversified exposure to 500 industrial giants in the US market. Its composition has changed significantly and as such the risk investors take being invested there. Most investors have unwittingly increased their risk.
So, while we do have exposure to many of the magnificent 7 in our clients’ portfolios because they are great companies, we do not hold them at the same levels as they are represented in the index. When markets are doing well, investors become complacent and forget to manage their exposure to risk. While the recent surge in big tech may not be a bubble just yet, the distortion in the composition of the index makes it more important than ever for investors to be cautious and prudent in their allocation of capital; not only across asset classes but in considering the underlying assets you hold.
General Advice Disclaimer: This information is of a general nature only and may not be relevant to your particular circumstances. The circumstances of each investor are different, and you should seek advice from an investment adviser who can consider if the strategies and products are right for you. Historical performance is often not a reliable indicator of future performance. You should not rely solely on historical performance to make investment decisions.