Executive summary:
- Today’s U.S. markets are highly concentrated, with nearly 70% of the economic profit in the S&P 500 Index generated by the top 10 companies. While there are some parallels to the dot-com era of the late 1990s, today’s high stock valuations are supported by solid fundamentals, including strong earnings growth, return on equity, and profit margins.
- Historically, active managers typically underperform during periods of extreme market concentration, because many tend to underweight mega cap companies.
- While the current environment is challenging for active managers, it also presents opportunities for skilled managers that can navigate the unique dynamics of the market by identifying idiosyncratic differences between mega cap companies.
At the Russell Investments 2024 Institutional Summit in Deer Valley, Utah, Megan Roach, Senior Director and Co-Head of Equity Portfolio Management at Russell Investments, and James Kim, Partner and Portfolio Manager at Intermede Investment Partners, discussed today’s highly concentrated market environment. The discussion was moderated by Kevin Turner, Managing Director of Institutional Partnerships and OCIO Solutions at Russell Investments. Below is a recap of the conversation.
Unpacking the dominance of the Magnificent Seven
The discussion began with a look at today’s high levels of market concentration and the implications of this on market dynamics and investment strategies. Roach and Kim stressed that a large share of the profits in the U.S. equity market today continue to be driven by the so-called Magnificent Seven companies—Apple, Microsoft, Alphabet, Amazon, Nvidia, Meta, and Tesla—and explored how active managers are navigating this environment of narrow market leadership.
One of the key points discussed was the distinction between market capitalization and economic value added. Market capitalization measures a company's share price multiplied by the number of shares, while economic value added considers a company's ability to generate profits beyond the cost of capital. Notably, nearly 70% of the economic profit in the S&P 500 Index comes from the top ten companies. As a result, it’s possible that the market might be undervaluing these firms when it comes to their overall importance to the U.S. economy.
How does today’s market environment compare to the dot-com era?
Roach and Kim contrasted the current market environment with the dot-com bubble of the late 1990s and early 2000s. During the dot-com era, stock valuations were based on expectations of high growth and profitability, which ultimately did not materialize. In contrast, today's high valuations, particularly among the Magnificent Seven, are supported by solid fundamentals such as earnings, profitability, and return on equity. The present market is seen as less speculative, with a price-to-earnings (P/E) ratio of around 27, compared to a much higher P/E ratio of 50 during the dot-com peak.
Despite the economic contributions of the Magnificent Seven, their market dominance raises concerns. The discussion considered whether the current market concentration poses risks, including the potential for overvaluation and vulnerability to economic downturns. Roach and Kim agreed that the differences between today’s environment and the dot-com bubble reduce the likelihood of a similar collapse.
Active management strategies in today’s environment
So, how are active managers navigating this environment of narrow market leadership? Many have chosen to maintain lower exposure to the Magnificent Seven companies compared to benchmarks, citing reasons such as the need for diversification, high valuations, and competition risks. These managers aim to invest in stocks where they have a unique perspective or analytical advantage, which can justify deviations from the benchmark.
The desire for diversification is a major factor for active managers. While the Magnificent Seven stocks hold significant weight in passive market indices, active managers prefer a more diversified portfolio. This allows them to invest in a broader range of stocks, which they believe offers better opportunities for finding undervalued investments. At the same time, this approach involves managing the balance between diversification and the risks of underperforming the benchmark.
Valuation concerns also influence investment decisions. The Magnificent Seven stocks, as a group, tend to have higher valuation multiples than the broader market. Active managers recognize that these high valuations imply significant future growth expectations, and that any failure to meet those expectations could result in large price corrections. So while many active managers hold these stocks, they are often hesitant to take overweight positions relative to market indices.
The importance of flexibility in investment strategies
Competition is another risk factor for the Magnificent Seven companies. Roach, Kim, and Turner discussed how the lines between different market segments have blurred, with companies that once operated in separate sectors now competing directly with each other. This includes competition in emerging fields like cloud computing and artificial intelligence (AI). Increased scrutiny from regulators and the potential for tighter regulations are also seen as challenges that could impact the future growth of these companies.
Roach, Kim, and Turner underscored the importance of flexibility and the ability to adjust investment strategies as market conditions change. They stressed that active managers must remain responsive to new information and shift their positions when valuations change or when the outlook for a particular stock evolves. Roach and Turner emphasized that the Magnificent Seven stocks are not a monolithic group, with each company presenting unique risks, opportunities, and growth potential that must be evaluated individually.
Key takeaways on the Mag 7 and active management
One of the key takeaways from the conversation was the impact of market concentration on active management performance. Historical data shows that active managers tend to underperform when market concentration is high, as is the case today amid the dominance of the Magnificent Seven. Conversely, active managers tend to outperform when market concentration decreases, as managers can better exploit inefficiencies in a more diverse market. Roach, Turner, and Kim stressed that while the current environment is challenging for active managers, it also presents opportunities for skilled managers that are able to navigate the unique dynamics of the market by identifying idiosyncratic differences between mega cap companies.
Roach and Kim concluded by highlighting their approach to managing multi-manager portfolios by balancing the contributions of different managers to achieve a desired overall positioning. This involves using a combination of strategies, from changing the allocation of managers to making adjustments through an active positioning strategy—which allows for more precise control over portfolio risk. The ultimate objective is to ensure that stock-specific risks, rather than broader market or factor risks, drive most of the portfolio's active risk.
Disclosures
These views are subject to change at any time based upon market or other conditions and are current as of the date at the top of the page. The information, analysis, and opinions expressed herein are for general information only and are not intended to provide specific advice or recommendations for any individual or entity.
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