Slimming Down a Top-Heavy Market

The strong performance of large-cap stocks over the past decade has left the market exceptionally top-heavy. By some measures, stock market capitalization has never been more concentrated among a handful of large stocks as today. The closest parallel to this level of concentration in modern market data is the late-1990’s technology bubble, reaching its peak in 2000. The current extreme is now comparable to that bubble peak, both in terms of the performance gap between the largest stocks in the S&P 500 index relative to the rest of the index, and in the lopsidedness of their market concentration.

One way to measure the persistence of outperformance by the largest stocks is to compare a market-value-weighted index of large stocks to its equal-weighted counterpart over a 10-year period. By 1999, a market-value-weighted index comprising the largest 30% of stocks (which is highly correlated to the actual S&P 500 Index) had outperformed its equal-weighted version by 2.6% annually over the prior decade. Such outperformance is unusual. In fact, capitalization-weighted portfolios have historically lagged equal-weighted portfolios by an average of 0.5% annually over 10-year periods. That 2.6% annual excess return marked a record for large-stock outperformance at the time. But in June of 2024 that record fell. The market-value version of this large-stock portfolio had outperformed its equal-weighted counterpart by 2.9% a year since 2014.

The second characteristic is the lopsidedness of the final push to the peak of market concentration. This can be measured by the percentage of stocks outperforming the index itself. The smaller the number of stocks outperforming the index in a given year, the more pronounced the outperformance of the largest stocks tends to be. Since 1990, an average of 52% of stocks in the S&P 500 have lagged the index in a typical year. In 1998, as market concentration approached its peak, 72% of stocks lagged the overall index. By 1999, the final full calendar year of the bull market, 68% of stocks in the index lagged behind the overall index.

These consecutive years of more than two-thirds of stocks lagging the index marked the end of the late 1990’s era of market concentration. In the years since, the percentage of stocks lagging the index has averaged just 48%, and has not exceeded 63%—until now. In 2023, 71% of stocks lagged the index, and last year, 72% did the same. This marks the only other instance in data since 1990 when more than two-thirds of stocks lagged the index for two consecutive calendar years.

Reaching levels of both persistence and lopsidedness of large-stock outperformance similar to those seen at the end of the last major peak in market concentration doesn’t guarantee an imminent end to the current dominance of large stocks. But it does suggest that the relative performance has become unusually overextended.

A major shift in relative performance could bring both opportunities and risks. The potential opportunity, often highlighted, is that an index of smaller stocks may achieve higher relative returns in the decade that follows. The risks typically associated with the unwinding of concentrated markets are less frequently discussed. Considering both the opportunities and the risks may be useful prior to an eventual unwinding of the current record market concentration.