The very rapid growth rates in companies associated with AI has fueled a further rise in the relative exposure of this sector, but it is about the same size as the energy sector on a relative basis at its peak in the 1950s.
What should investors do about it?
While we like technology and are overweight in all regions, GS thinks there are good opportunities to hedge technology dominance by:
A. Diversifying technology exposure with selected ‘growth’ that is cheaper.
One way to diversify from technology is to supplement it with other growth exposures. Healthcare is a sector that we overweight in all regions (except Japan). It remains relatively cheap but also has high prospective growth. Furthermore, in time, we see this sector as being a beneficiary of AI technologies.
Another growth diversifier is the European GRANOLAS, 11 of the largest companies in the STOXX 600. These stocks trade at a lower valuation (around 20x P/E) than the Magnificent 7 and have performed well. They share some similar characteristics to the technology leaders; they have strong balance sheets, are reporting high profits, and have similarly high and stable margins.
B. Diversify into the Ex Tech-Compounders (the ETCs).
GS has put together a list of global ETCs, which can be found in the Appendix. The list looks for companies that have market caps above $10bn and have high margins (EBITDA > 14%, EBIT > 12%, Net Income > 10%), high profitability (ROE > 10%), strong balance sheets (ND/Equity < 75%, ND/EBITDA < 2x), low volatility (Vol < 50), strong growth prospects (sales > 4% and earnings > 8%) and have consistently grown their earnings over the past decade.
C. Complement Quality Growth with some Value.
3. Concentration by stock; the growth of the Magnificent 7 and GRANOLAS
In the US, the 10 largest companies have reached over 30% of the market value of the S&P 500, the highest level since 1980. Does high stock market concentration reflect a bubble? While high stock market concentration may be a sign of a bubble, it does not necessarily mean there is one. For example, when Japan’s stock market briefly became the world’s largest, and reached a P/E of 67x, the biggest companies in the index were banks, but the market was not particularly concentrated. Furthermore, while the biggest stocks in the US equity market are much bigger today as a share of the market compared with the stock market bubble of 2000, current valuations are much lower than have been typical in other recent bubble periods, stretching back to the Nifty 50 era of the early 1970s, the Japanese bubble in the late 1980s, and indeed the technology bubble in 2000. Perhaps more importantly, however, the current dominant companies are much more profitable and have stronger balance sheets than those that dominated during the tech bubble. Furthermore, high stock concentration is not unusual. As Exhibit 29 below shows for the US equity market, the biggest company over time has often been bigger than the biggest company today.
Understanding the Fed’s signals in a shifting economy: Investment strategies to consider
US economics, inflation, and the Fed
The nation added an estimated 275,000 jobs in February, exceeding both the consensus expectation of 198,000 and the previous month’s figure of 229,000. However, the estimated January number was revised lower by 124,000, and the accompanying unemployment rate rose from 3.7% to 3.9%. The report also showed a decrease in the pace of average hourly wage growth, to 0.1%, a continuation of which may be needed to slow consumer spending enough to make a further dent in inflation according to Value Line.
Federal Reserve Chairman Jerome Powell said in recent testimony before Congress that the central bank is close to cutting the federal funds rate. However, Mr. Powell’s remarks came before the latest hotter-than-expected reading on consumer prices. Specifically, the Consumer Price Index (CPI) and the core CPI, which excludes the more-volatile food and energy components, both rose 0.4% on a month-to-month basis. On a 12-month basis, the CPI and core CPI increased 3.2% and 3.8%, respectively, both exceeding expectations.
Professor Siegel commented lately:
“The Consumer Price Index (CPI) and Producer Price Index (PPI) were slightly disappointing last week, which reinforces the hawks on the FOMC committee who are more resistant to lowering interest rates. However, I am not concerned about inflation, as the core year-over-year inflation remains biased by the very lagged shelter data — which drove 2/3rds of the increase in the core CPI year over year. When we substitute real time indicators like those from Apartment List National Rent Report, real inflation is more like 1-2% instead of almost 4%.
The sensitive commodity prices stopped going down and are beginning to show some firmness — particularly oil. The big downturn over the last two years in the Bloomberg Commodity Index has now flattened out and bottomed. We will have to watch this, but it is not overly concerning. On the real economic data side, the February retail sales were somewhat disappointing, but the economy is still rolling along at a healthy level. Estimates for real gross domestic product (GDP) in the current quarter are tracking around 2% with the economy showing no apparent signs of weakness — which will further embolden Fed members who do not want to cut rates.”
At their last meeting Federal Reserve officials didn’t significantly change their outlook for delivering interest-rate cuts later this year despite solid growth and firmer-than-anticipated inflation in recent months. Most officials penciled in three rate cuts this year in new projections, the same as in December. The central bank held steady its benchmark federal-funds rate in a range between 5.25% and 5.5%, a 23-year high.
Global economy
JP Morgan continues to forecast resilient growth, sticky inflation, and limited developed markets (DM) easing. As the US economy slows down, the evidence for broadening global growth (by region and sector) remains limited: activity readings have yet to show a convincing revival in Western European or Japanese consumption or a pickup in global factory output. However, ongoing upside US growth surprises and constructive signals elsewhere — from labor markets to global Purchasing Managers’ Index (PMI) and consumer sentiment surveys — point in the right direction. More clear-cut evidence supports JP Morgan’s view that disinflation will stall at a still-elevated 3% annual rate during 1H24. Globally goods price disinflation looks to have ended while service price inflation remains sticky. In the US and Europe prices are rebounding following depressed paces last quarter. These developments align with a shallow DM policy easing starting around midyear, which is now embedded in central bank guidance and market pricing.
Prospects for sustained high-for-long policy stances should weigh on growth by promoting tighter financial conditions and increasing debt service costs. With tight labor markets sustaining elevated wage gains, diminished corporate pricing power and modest productivity gains should also compress profit margins. This erosion of private sector health underscores JP Morgan’s “boil the frog” narrative of a gradual path to an expansion end. Several recent developments bolster the case for an alternative soft-landing scenario, however, in which growth is sustained in the face of limited central bank easing.
These developments are connected, raising the prospect that the DM expansion may be able to survive higher policy rates than is commonly perceived. JP Morgan still predicts the global economy to expand at a 2.4% real annual growth in 2024.
Stock market: Concentration
In their recent paper Goldman Sachs (GS) analyzes the elevated stock market concentration. Overall, it has increased dramatically and has taken three broad forms: the rise in the share of the US equity market in the world, the rise in the share of the technology sector, and the rise in the dominance of the biggest companies in most regions. But, does it really matter for investors that markets have become more concentrated and what, if anything, can they do about it? In the paper GS looks at each of these areas of increased market concentration, places them in historical context, and looks at the implications and possible investment strategies to hedge concentration risk. Market dominance is not unprecedented and is only a problem if it is not supported by fundamentals. That said, at the stock level in particular, dominant companies rarely stay the best performers over long periods of time. GS therefore examines strategies to diversify.
1. Market concentration by country: US equity market hegemony
The US equity market has seen an extraordinary rise in value since the global financial crisis (GFC), strongly outpacing that of other major markets, and taking its share of the global equity market to 50%. This is high by historical standards, although not unique. The equity market had a higher share in the global markets in the early 1970s, although the drivers were very different. In that period, the seven largest companies belonged to the oil sector (Exxon and Mobil), the autos sector (Ford, GM and Chrysler) together with General Electric and IBM.
Over the following 50 years, the US equity market has consistently been the world’s biggest, although it briefly fell to less than 30% of the world in the late 1980s, when it was overtaken by Japan. At the peak of its bubble in 1989, the Nikkei hit 38,915 — a level that it has recently finally surpassed over nearly 35 years later. The four biggest companies in the world in 1989 were all Japanese banks (Industrial Bank of Japan, Sumitomo Bank, Fuji Bank and Dai-Ichi Kangyo Bank). Six of the 10 biggest companies in the world were Japanese. In the aftermath of the collapse of the Japanese market, the US once again resumed its leadership in the global equity market.
The outperformance of the US equity market since the Great Financial Crisis (GFC) has mapped the outperformance of the ‘Growth’ factor, particularly relative to the rest of the world. Put another way, the US stock market has more exposure to faster growing industries than the rest of the world, and less exposure to slow growing companies. That said, while fundamentals have driven the ascent of the US, its equity market has also become increasingly expensive relative to the rest of the world, even when taking into account the differences in sector weights.
What should investors do about it?
GS believes the best diversification opportunity in DM is Japan, which they view primarily as a restructuring opportunity, which they like and are overweight. GS sees the best diversification opportunities overall, however, in emerging markets. In their view, India, in particular, is a good Growth opportunity; China offers good diversification and is a Value opportunity; and the Middle East also offers good diversification characteristics although GS view here is more mixed. There are many companies outside of the US that should be considered as part of a global diversified portfolio and should not be ignored simply because their base and listing location is outside of the US. Many quality growth companies exist in other regions that have globally diversified revenue streams and could be useful diversifiers in a US-dominated portfolio.
2. Market concentration by sector; the rise of Technology
Another form of market concentration that has emerged in markets over recent years is at the sector level, particularly with the rise of the technology sector. Once again, this is more obvious in the US than in other markets, but it has become a feature of many other markets too, particularly in Asia. It is also worth remembering that the current dominance of the technology sector, even in the US equity market, is not unprecedented relative to other dominant sectors in the past. Exhibit 14 below shows the biggest sector in the US equity market over time. The Information Technology and Communications industry is the biggest, but this is by no means exceptional. Over the past 200 years, the biggest industry represented in the stock market at each point in time has reflected the major driver of economic growth. The Technology sector is about the same size as the Energy sector was at its height in the mid-1950s. It remains smaller in the index than both Transport (which dominated in the 20th century) or finance and real estate which drove the dominant part of the equity market in the 19th century.
The very rapid growth rates in companies associated with AI has fueled a further rise in the relative exposure of this sector, but it is about the same size as the energy sector on a relative basis at its peak in the 1950s.
What should investors do about it?
While we like technology and are overweight in all regions, GS thinks there are good opportunities to hedge technology dominance by:
A. Diversifying technology exposure with selected ‘growth’ that is cheaper.
One way to diversify from technology is to supplement it with other growth exposures. Healthcare is a sector that we overweight in all regions (except Japan). It remains relatively cheap but also has high prospective growth. Furthermore, in time, we see this sector as being a beneficiary of AI technologies.
Another growth diversifier is the European GRANOLAS, 11 of the largest companies in the STOXX 600. These stocks trade at a lower valuation (around 20x P/E) than the Magnificent 7 and have performed well. They share some similar characteristics to the technology leaders; they have strong balance sheets, are reporting high profits, and have similarly high and stable margins.
B. Diversify into the Ex Tech-Compounders (the ETCs).
GS has put together a list of global ETCs, which can be found in the Appendix. The list looks for companies that have market caps above $10bn and have high margins (EBITDA > 14%, EBIT > 12%, Net Income > 10%), high profitability (ROE > 10%), strong balance sheets (ND/Equity < 75%, ND/EBITDA < 2x), low volatility (Vol < 50), strong growth prospects (sales > 4% and earnings > 8%) and have consistently grown their earnings over the past decade.
C. Complement Quality Growth with some Value.
3. Concentration by stock; the growth of the Magnificent 7 and GRANOLAS
In the US, the 10 largest companies have reached over 30% of the market value of the S&P 500, the highest level since 1980. Does high stock market concentration reflect a bubble? While high stock market concentration may be a sign of a bubble, it does not necessarily mean there is one. For example, when Japan’s stock market briefly became the world’s largest, and reached a P/E of 67x, the biggest companies in the index were banks, but the market was not particularly concentrated. Furthermore, while the biggest stocks in the US equity market are much bigger today as a share of the market compared with the stock market bubble of 2000, current valuations are much lower than have been typical in other recent bubble periods, stretching back to the Nifty 50 era of the early 1970s, the Japanese bubble in the late 1980s, and indeed the technology bubble in 2000. Perhaps more importantly, however, the current dominant companies are much more profitable and have stronger balance sheets than those that dominated during the tech bubble. Furthermore, high stock concentration is not unusual. As Exhibit 29 below shows for the US equity market, the biggest company over time has often been bigger than the biggest company today.
Is high stock concentration a big risk?
Historically, with new entrants emerging, few companies remain unscathed as competition either forces companies to disappear, merge or be acquired. From this perspective, a market that becomes dominated by a few stocks becomes increasingly vulnerable to either disruption or anti-trust regulation. There are, for example, only 52 companies that have appeared every year in the Fortune 500 since 1955. In other words, just over 10% of the Fortune 500 companies in 1955 have remained on the list during the 69 years through this year 2. Based on this history, it would appear reasonable to assume that when the Fortune 500 list is released 70 years from now in the 2090s, almost all of today’s top companies will no longer exist as currently configured and will be replaced by new companies in new, emerging industries that we can’t even imagine today.
Innovation tends to generate new technologies, products, and markets; alongside these, stock market leadership also tends to change. This process sometimes accelerates or slows down but since 1980, for example, more than 35% of S&P 500 constituents have turned over during the average 10-year period, largely reflecting innovation. Of the current top 50 companies in the US, only half of them were in the top 50 a decade ago, and many companies did not even exist before the 1990s (NVIDIA(1993), Amazon (1994), Netflix (1997), PayPal (1998), Alphabet (1998), Salesforce (1999), Tesla (2003) and Facebook (2004)).
While absolute returns remain good for the dominant companies, these strong returns fade over time. Importantly, however, the returns are generally negative for dominant companies if an investor buys and holds them as other faster-growing companies come along and outperform them. Nevertheless, this does not mean that these companies would necessarily be poor investments. They may well remain good compounders, be more defensive and enjoy lower volatility and higher risk-adjusted returns.
What should investors do about it?
Investors face a flatter trajectory for equity markets over the next few years as a higher cost of capital and less globalization mean lower returns. Under these conditions, GS thinks investors should employ a barbell approach:
Signet approach
We agree with Goldman’s points in the paper cited above. As we manage our active portfolios and passive allocations, we combine the tactical and secular approaches and diversify away from unnecessary concentration.
The information and opinions included in this document are for background purposes only, are not intended to be full or complete, and should not be viewed as an indication of future results. The information sources used in this letter are WSJ.com, Jeremy Siegel, Ph.D. (Jeremysiegel.com), Goldman Sachs, J.P. Morgan, Empirical Research Partners, Value Line, BlackRock, Ned Davis Research, First Trust, Citi research, and Nuveen.
IMPORTANT DISCLOSURE
Past performance may not be indicative of future results.
Different types of investments and wealth management strategies involve varying degrees of risk, and there can be no assurance that their future performance will be profitable, equal to any corresponding indicated historical performance level(s), be suitable for your portfolio or individual situation, or prove successful.
The statements made in this newsletter are, to the best of our ability and knowledge, accurate as of the date they were originally made. But due to various factors, including changing market conditions and/or applicable laws, the content may in the future no longer be reflective of current opinions or positions.
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LET'S GET ACQUAINTED