AUTHORS | Richard Saldanha, Senior Portfolio | Joao Toniato, Head of Global Equity
CONTRIBUTOR | Andrea Carzana
Soaring technology share prices have driven US stock market concentration to unprecedented levels and pushed the US market to a record premium relative to other markets. While both trends could persist, investors need to be aware of the implications, argue Richard Saldanha and Joao Toniato.
Read this article to understand:
- Why investors need to be aware of the risks posed by technology companies’ dominance
- Why there may be opportunities beyond the biggest tech firms to profit from themes such as artificial intelligence
- Which other sectors look best placed if the equity rally broadens out
Alphabet, Amazon, Apple, Meta, Microsoft, Nvidia, Tesla: this group of leading tech firms has been dubbed the “Magnificent Seven” thanks to its stellar performance and rising dominance of the US stock market.
Last year, these companies’ rapid growth meant they grabbed a much bigger share of the S&P500 Index, pushing the concentration of the US stock market to unprecedented levels that surpassed even those seen during the “dot.com” era a quarter of a century earlier. This simultaneously left US stocks valued at a record premium relative to European peers.
Figure 1: Outsized returns of the Magnificent Seven (indexed to 100)
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Source: Aviva Investors, Goldman Sachs. Data as of March 26, 2024.
Although there are some signs the US equity rally may be starting to broaden out as other sectors of the market belatedly catch up, concentration in the US market remains extremely high. Some commentators believe the dominance of the US technology sector is justified, not least given developments in generative artificial intelligence (AI), which are already boosting several companies’ profits despite the commercial applications of the technology still being in their infancy.
Likewise, others see little need to call time on the era of US exceptionalism, arguing economic growth in the US will continue to outstrip that in Europe and beyond. That would in turn enable US companies to go on growing earnings faster than their global peers.
However, while the rally in the big US technology stocks could outpace the wider market and help sustain the US market’s stunning outperformance for a while longer, rising concentration and some sky-high valuations could be creating risks.
Passive risks
Richard Saldanha, who manages the Aviva Investors Global Equity Income strategy, says unprecedented levels of concentration in US stock indices could be exposing investors, especially those in passive equity funds, to risks they may be unaware of.
“If you’re a US passive investor, you may believe you’re getting broad market exposure, but the fact remains 30 per cent of your money is in just seven stocks. Even if you’re exposed to global equities, the dominance of the US market means the same seven stocks account for 18 per cent of your investment,” he says.
Figure 2: Seven largest companies as share of S&P 500 market capitalisation (per cent)
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Source: Aviva Investors, Goldman Sachs. Data as of March 26, 2024.
It is quite conceivable the US market’s high degree of concentration persists a while longer, given the scale of investment flowing into passive funds and signs that hedge fund investors have been snapping up shares as they look to reduce the size of “short” bets on the sector.
Nonetheless, even if a sudden reversal may seem unlikely, history suggests current levels of stock market concentration will not persist indefinitely.
“While we may not know when some of these stock valuations normalise, they almost certainly will at some point. You don’t want to be stuck on the wrong side of that trade when they do,” Saldanha says.
Predicting what will cause such a shift is a “fool’s errand” in his eyes, although the growing threat of regulatory intervention is one candidate. To try to inject greater competition into various markets, authorities on both sides of the Atlantic are stepping up efforts to curb big technology companies’ dominance and perceived market abuse.
The US government on March 21 launched an antitrust case against Apple, alleging it has illegally stifled competition by restricting access to its software and hardware.
Less than a week later, the EU launched probes into whether Apple and Google owner Alphabet were unduly favouring their own app stores. It said it will simultaneously investigate Facebook owner Meta’s use of personal data for advertising. Under the Digital Markets Act, each company faces a fine of up to ten per cent of its global revenue if found guilty of non-compliance.
Finding diversification
Given the difficulties in predicting when tech sector valuations may begin to normalise, and the dominant size of the biggest seven companies, portfolio managers such as Saldanha are facing a dilemma.
Shunning these seven stocks altogether could result in unacceptably high tracking error. In other words, should they continue to outperform the wider market, such a portfolio would be liable to badly underperform its benchmark. And unlike the bubble that formed during the dot.com era, today’s US tech giants are hugely profitable businesses with entrenched positions that most believe will continue to dominate their respective industries.
Then again, owning such richly valued shares runs counter to the philosophy of those managers seeking undervalued stocks. After all, doing so simply to limit the risk of underperforming the wider market negates the rationale for pursuing an active investment approach.
“We're aware of how the benchmark looks, but that's never the starting point. The most important element for us is making sure our own portfolios are sufficiently diversified irrespective of what the benchmark composition is. When it comes to the Magnificent Seven, ultimately the question one needs to ask is: is the price you're paying justified? If it isn’t we simply don't own them,” Saldanha says.
On the balance of probability, he believes it is questionable these seven companies continue to dominate to the same extent or take as big a portion of the index over the longer term.
That said, both he and Aviva Investors chief equity strategist Joao Toniato argue that while the level of concentration within the US stock market may look unsustainable, it would be a mistake to lump all seven of the biggest tech companies into the same bucket. An unusually high degree of correlation between their shares last year left some valuations looking excessive, while in other instances rising share prices appear more warranted. As such it is important to distinguish between different companies.
Some valuations, such as that of Tesla, which was trading on a 12-month forward price/earnings ratio of around 60x as of March 4, are arguably difficult to justify. Amazon, trading at c39x at the same date, also poses a challenge. Others, such as Alphabet, were trading on much less demanding multiples of around 20x earnings. Nvidia and Microsoft were trading at forward P/Es of around 30x. While that is not cheap relative to a market trading on a forward P/E of around 20x, both companies are expected to be big beneficiaries of the growth in AI.1
“It would be wrong to characterise the Magnificent Seven as a bubble. Some shares have been driven much higher than fundamentals seem to justify. But in other cases there were solid fundamental reasons for the outperformance,” Toniato says.
Market scrutiny
He adds greater differentiation in performance in recent weeks suggests the market is starting to scrutinise individual share valuations more closely.
“We’ve seen a sizeable correction in Tesla, while Apple has underperformed slightly as well. These seven stocks are gradually starting to trade a bit more in line with their fundamentals,” Toniato says.
Figure 3: US equities premium over European equities, based on forward price/earnings ratio (per cent)
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Source: Aviva Investors, Macrobond. Data as of March 27, 2024.
Nevertheless, the rally in those stocks and its effect on the broader US market has helped push the US to a record premium relative to Europe.
But Toniato says while the US market may look expensive on some metrics, its valuation starts to look far from extreme if you strip out the Magnificent Seven.
Saldanha agrees. “Some people are forgetting there are 493 other stocks in the S&P500 that by and large are trading on P/E multiples which are in line with or in some cases below historic averages and which in many cases offer decent growth prospects, and also have the ability to benefit from AI,” he says.
Echoing that view, fellow Aviva Investors equity portfolio manager Andrea Carzana says while uncertainty over the long-term impact of mega-trends such as AI makes it very difficult to value some technology shares, it is still possible to find companies whose growth potential is arguably not being fully recognised by the market. “Generative AI has been the main focus for the past year, but the market is slowly realising it is not only chip companies that are set to benefit.”
For example, companies supplying electrical equipment and a variety of other services to data centres are likely to be big beneficiaries. Likewise, US utilities will need to upgrade their grid networks to supply sufficient power to these data centres, providing a potentially lucrative market for other firms supplying the equipment.
“These markets are enjoying double-digit growth rates, driven both by strong volume and pricing. We expect these growth rates to be sustained in the medium term as the adoption of generative AI by a growing number of businesses fuels demand for computational power, networking and memory,” Carzana.
Notwithstanding its rich valuation, Toniato is optimistic on the outlook for the US market over the next 12 months. While prices could be vulnerable should a renewed spurt of inflation prevent US rates from falling as fast as anticipated, or in the event the US economy slows faster than expected, neither is his central scenario.
He says there is every reason to believe the US economy will perform comparatively well as productivity gains outpace those seen elsewhere, and as the US lures high levels of capital investment from foreign firms that are attracted by a strong economy and lucrative tax incentives designed, among other things, to boost infrastructure investment.
Healthy earnings growth and a gradual reduction in US interest rates should support a further rise in stock prices.
“US corporate earnings appear to have troughed in the middle of 2023. We are not expecting massive growth, but if we are at the start of a new earnings cycle, even if it proves to be a modest one, that should lift stock prices, particularly as it appears US rates have peaked and rate cuts could provide further support for equities.”
Nonetheless, US stocks may struggle to outperform other developed markets to the same extent as they did in the period following the Global Financial Crisis. Expectations for European corporate earnings are much less demanding than for US earnings, and valuations are below the long-term average, which could make them very attractive if we are indeed at the beginning of a new earnings cycle. Should the US equity market rally begin to broaden out, that could potentially point to other markets outperforming, given the technology sector has a far smaller weighting in non-US indices.
“We would expect sectoral differences to be a bigger driver of outperformance than regional ones this year. If we are in a new earnings cycle, some areas of technology, such as semiconductors, should continue to do well, but other cyclical businesses such as banks, industrials and commodities should also outperform. That would favour European markets where these sectors have a comparatively bigger weight,” Toniato says.
It is also worth considering which sectors could take up the mantle should some of the current leadership change. Saldanha says two that stand out currently are healthcare and consumer staples. From a valuation standpoint both sectors suffered a material de-rating versus the broader market in 2023 yet for the most part still delivered resilient earnings and cash flows.
He believes investors may be underappreciating this resilience, especially given the uncertain geopolitical backdrop and the number of elections taking place around the world this year.
“We believe the opportunity set for active fund managers remains attractive, especially given the divergence we are seeing in valuations across sectors and companies. No one can predict the future, but we think it's better right now to have a portfolio that is as different to the benchmark as it has been for a long time,” Saldanha says.
Reference
- Source for all figures is Bloomberg, as of March 4, 2024.
