Do the Markets Have a Concentration Problem?

As concerns over the labor market eased and the hotly contested U.S. election concluded, investors became more optimistic about economic and market prospects toward the end of 2024. Despite continued labor market resiliency and bullish investor sentiment, market returns were muted during the fourth quarter with a narrow group of stocks leading the way much as they did during the second quarter of this past year.  

During the fourth quarter, the MSCI All Country World Index, which is the broadest global equity index (it includes 23 developed and 24 emerging markets) fell 0.99 percent. However, beneath the surface of that expansive index, leadership was again concentrated in the United States as the S&P 500 index advanced 2.39 percent. For the year, the S&P 500 gained 25.02 percent, while the MSCI All World Index was up significantly less at 17.49 percent.  

Once again, this growth was powered by just seven of the largest U.S. technology stocks, commonly known as the “Magnificent Seven.” These seven stocks rose 9.95 percent on a market-cap-weighted basis during the quarter and gained 48.5 percent for the year. The Magnificent Seven accounts for 33 percent of the total S&P 500 market capitalization. Because of that, the seven stocks’ performance was more than enough to pull the index into positive territory.  

Simply put, the market-capitalization-weighted S&P 500 posted a solid quarter, while other market returns were muted and, in some cases, negative, again highlighting the outsized impact that a narrow group of industries and companies had on performance.

If you remove their outsized impact and look at all stocks in the index the same, the equal-weighted S&P 500 actually declined 1.89 percent during the fourth quarter (and was up a more muted 12.98 percent for the year). This is the same dynamic that played out in the second quarter, when the market-cap-weighted S&P 500 gained 4.28 percent while the equal-weighted version fell 2.63 percent. Overall, these seven stocks had a huge impact on growth of the S&P 500 in 2024. 

Weak market breadth was also evident elsewhere in our nine asset class portfolios, with international equities falling 8.11 percent (in U.S. dollars), while smaller and mid-sized U.S. stocks fell 0.59 percent and rose 0.33 percent respectively. For the year, small cap stocks as represented by the S&P Small Capo 600 Index were up 8.65 percent. Mid-cap stocks as captured by the S&P MidCap 400 Index rose 13.93 percent. Reflecting the resiliency of the labor market and aggregate U.S. consumer, coupled with increasing inflation expectations, the two-year Treasury rose from 3.64 to 4.24 percent, while the 10-year Treasury yield climbed from 3.78 percent to 4.57 percent in the quarter (yields and prices are inversely correlated). This pushed down fixed income returns, with the Bloomberg U.S. Aggregate Index falling 3.06 percent (up 1.25 percent for the year), while interest rate-sensitive Real Estate Investment Trusts (REITs) fell 5.93 percent (but up 8.1 percent for the year). Commodities were relatively unchanged, down just 0.45 percent for the quarter. For the year, the group was up 5.38 percent. 

Simply put, the market-capitalization-weighted S&P 500 posted a solid quarter, while other market returns were muted and, in some cases, negative, again highlighting the outsized impact that a narrow group of industries and companies had on performance.    

They love me, they love me not 

If the above return pattern sounds familiar, it’s because it follows an on-and-off-again narrative that’s prevailed since the fourth quarter of 2023. In the aftermath of easing inflation, the Federal Reserve expressed optimism that it could begin easing rates, and investors priced in fast and aggressive rate cuts in early 2024. This optimism led investors to bid up broad swaths of the equity markets to close out 2023 and into early 2024 based on hopes that lower rates would ease the pain on interest rate- and economically sensitive businesses, therefore broadening economic growth. However, that narrative quickly shifted late in the first quarter and during the beginning of the second quarter. The change came as signs of sticky inflation dampened expectations about the number and timing of rate cuts and bond yields moved higher. As investors concluded the Fed would take a muted approach to cutting rates, they moved away from broad market exposure and flocked to the perceived safety and interest rate-insensitivity of the Magnificent Seven. The group trounced the rest of the market beginning late in the first quarter and throughout the second quarter. The result was a historically narrow market.  

The narrative once again shifted rapidly in early July. Indeed, a weak jobs report and encouraging inflation data raised the prospects of the Federal Reserve cutting rates, which pushed Treasury yields lower and caused investors to once again reverse course and look to a broader set of equities. Indeed, as expectations of rate cuts grew, Small-Cap stocks (which traditionally are more sensitive to economic growth and interest rates) outperformed the S&P 500 by nearly 14 percent and the Magnificent Seven by 23 percent in the span of just 20 days in July. The overall result was a broad market advance that included companies and industries of all shapes and sizes.  

Market strength was broad at the start of the fourth quarter with investors once again rapidly pricing in interest rate cuts from the Federal Reserve in response to weak labor market readings that were building over the summer. The Fed cut rates three times, including the 50-basis-point cut that kicked off the cycle in September. Chairman Jerome Powell even explicitly stated, “We do not seek or welcome any further deterioration in labor market conditions.” Then the broadening trend began to reverse as two important events occurred:  

1. Investors were reminded that the Fed controls only the front end of the yield curve. Indeed, since the Fed began cutting rates in September, yields on two-year Treasurys have risen by 70 basis points, while yields on 10-year Treasurys have increased by 95 basis points. 

2. Leading up to and at their Dec. 18 meeting, the Fed began tamping down rate cut expectations which led investors to shift the forecasts that the Fed funds rate would end 2025 a low of 2.8 percent to now 3.9%.   

Once again this led investors to return to the interest rate-insensitivity of the Magnificent Seven as we noted in our opening, and once again market strength narrowed dramatically.  

We highlight this flip-flop to bring to light the impact that interest rates have had on equity markets over the past year. Throughout this year, market leadership and breadth has been uniquely impacted by changes in expectations of Fed policy. Put simply, when interest rates have faltered, equity markets have broadened; conversely, when they have risen, equity markets have narrowed. 

This makes sense in the nearer term  

We have always believed that the economy and the market are connected. However, the time horizons don’t always line up for people to easily make or take advantage of that connection. Interest rates and rate cut expectations are clearly impacting markets. While overall economic growth remained strong in 2024, it was bumpy and bifurcated—with the difference being those individuals, industries and companies that have been negatively impacted by rising rates versus those that have not or, in some cases, have actually benefited.  

This bifurcated economic backdrop has led to a similarly bifurcated equity market in which there have been haves and have-nots.

The reality is that many parts of the U.S. economy have been affected by rising interest rates over the past couple of years and continue to feel the burden. Think about lower- to middle-income consumers who have exhausted excess savings and are feeling the pinch of higher interest rates on credit cards and auto loans while also dealing with the impact of higher prices. Similarly, manufacturing and the housing industry, which are interest rate-sensitive, have been in the doldrums for much of the past couple years. Finally, smaller companies have had to grapple with declining pricing power and variable rate debt. Contrast that with higher-income consumers who are now earning interest on their savings and have little to no variable-rate debt, houses financed with lower fixed-rate debt (which appreciated to record levels), and equities that have done the same. Or think about the aforementioned companies that are tied to the secular theme of artificial intelligence.  

This bifurcated economic backdrop has led to a similarly bifurcated equity market in which there have been haves and have-nots. This has shown up in the earnings of the companies that are sensitive to interest rates versus those that are not. This dynamic, we believe, has led to the narrow market leadership of the past two years.    

Fundamentally, top- and bottom-line results far exceeded the index averages this past year for the six of the seven “Magnificent” companies, as the buildout of artificial intelligence infrastructure is having an outsized, positive impact on these firms. More specifically, earnings grew almost 40 percent in aggregate for the six largest technology companies (Apple, Amazon, Google, Meta, Microsoft and Nvidia). In contrast, earnings for the remaining 494 companies in the S&P 500 grew around just 5 percent.  

While long-term earnings growth and the price investors pay for those (Price to Earnings or P/E multiples) have a powerful influence on intermediate- to long-term stock returns, in the shorter term it doesn’t have as much of an impact. On the other hand, earnings revisions are one of the most powerful equity factors in driving shorter-term performance. Earnings revisions can be measured in a variety of ways, but simplistically a revision occurs when consensus estimates for a fundamental metric (i.e., earnings, revenues) move either up or down over a forecast period.  

Evaluating 2024 through this lens gives further insight into why market returns were so concentrated. Throughout the year, the top six technology companies had a very strong positive 33 percent earnings revision trend, while the rest of the collective 494 saw a negative 6 percent earnings revision trend. Simply put, earnings came in roughly 33 percent higher than expected for the largest technology companies and collectively 6 percent worse than expected for everyone else. 

With a lack of other strong earnings revision stories in 2024 given some of the relative economic weakness, investors were increasingly willing to pay more for these six companies. Aided by multiple expansions, the average price return for these technology companies was about 60 percent in 2024, which, combined with their collective 33 percent weight in the index, puts the total contribution at 11.55 percent. That’s 46 percent of the total return of the entire S&P 500 coming from just six companies—with standout Nvidia’s contribution registering at 20 percent of the entire return. 

Putting it all together, there were macroeconomic, monetary, equity factors and fundamental reasons for the concentrated profile of returns in 2024. The result was just 29 percent of companies in the S&P 500 outperforming the aggregate index. This percentage is well below the long-term average of 48 percent. Combine this with a similar reading in 2023, and it’s tempting to draw parallels to the market dynamics of the late 1990s. 

But how long can this continue? 

In order for the economy to continue to expand over the intermediate term, we believe that overall economic growth needs to broaden. Certainly, over the past couple of years growth in the strong parts of the economy has been robust enough to make up for the laggards. But risks are higher when only a few parts of the economy are healthy. This is where we believe economic weakness often unveils itself in the labor market. And unlike the top-heavy financial markets, which can be dominated by the largest companies, small businesses in the United States employ nearly half of all workers in America.   

Simply put, when the overall labor market begins to weaken, at least historically it has reached critical mass when enough individuals are out of work that it leads to a downturn in overall economic growth. This is why the Fed is so fixated on the labor markets and was the reason it cut rates aggressively in September after Chair Powell’s comments. At that time the labor market was showing signs of increased weakness, and the Fed worried it had reached or was nearing the tipping point. Recall that the unemployment rate had risen from 3.7 percent to begin the year to 4.3 percent by July. The rise triggered the “Sahm Rule,” which was created by former Fed economist Claudia Sahm as a way to quantify, at least using history as a guide, when gradual job losses began to accelerate. And while many noted that the rise was due to an increase in the total number of people in the labor market, we point out that the total number of those employed according to the Household employment report has actually declined since July 2023.  

As regular readers will know, the unemployment rate is calculated using the Bureau of Labor Statistics (BLS) Household report. This is one of two jobs reports and is a tally of the number of people who respond to the BLS’s survey saying that they are working. The other jobs report, the Establishment survey (counts the number of establishments that report having jobs) has remained strong. However, the establishment data has increasingly been revised downward, resulting in the number of individuals added to private payrolls coming in at fewer than 100,000 in June, July and August—with a potentially hurricane-impacted October reported as “slight job losses.” Additionally, reflecting economic bifurcation, the diffusion index, which shows the percentage of industries that are hiring, fell to levels that in the past have preceded economic contractions. The good news as we enter 2025 is that this trend has modestly reversed.  

We highlight this economic bifurcation because it historically has coincided with market bifurcation. Later in economic cycles, the economy has often experienced gradual deterioration, typically as high interest rates hit the most sensitive areas first and then slowly work their way through the economy. This spills over to markets as companies that are harmed fail to produce earnings, while those that are not continue to grow. The market narrows.  

The above chart shows the percentage of companies (stocks) in the S&P 500 that produced returns above the market-cap-weighted index. As we’ve discussed, despite the back-and-forth over the past year or so, 2024 marked the second year in a row in which fewer than 30 percent of companies beat the overall index return. To find similar numbers in the past (on an annual basis) you’d have to go back to 1998 and 1999 and before that 1980 and 1973. We don’t believe it is simply coincidence that these occurred in periods that either coincided with or led to economic contractions. Simply put, the weakening economy was pulling more companies into declining growth, with only a few continuing to shine. And we don’t believe it’s coincidence that in the years after, markets broaden as economic growth begins to broaden again.  

Looking at this from the perspective of our earlier commentary about the market-cap-weighted index relative to the equal-weighted S&P 500 draws a similar parallel. As shown in the chart below, the market-cap-weighted S&P 500 trounced the equal-weighted index for the second year in a row by an amount not seen since the late 1990s.  

The equal-weight index is in the midst of its second worst relative performance drawdown in the last 35 years. This is because of the growing concentration in the market that reflects an economy in which growth is increasingly concentrated. Put another way, the markets are out of balance, and over time they’re likely to return to a more balanced state. As such, we believe that investors should continue to be disciplined as it relates to the time-tested benefits of diversification in the context of a battle-tested, long-term plan. 

And as we’ve seen during other periods, narrow markets eventually give way to broader participation among stocks and asset classes.

This issue is not limited to the S&P 500 but more so for segments of the market that are sensitive to the economic cycle, such as smaller capitalization companies. Indeed, as the two charts below show, the S&P 500 index of Large-Cap stock companies beat the S&P 600 index of smaller companies and the S&P 400 index of Mid-Cap stock companies last year by the largest amount since 1998.  

This time period is certainly unusual, but as the charts show, we’ve seen situations like this before. And as we’ve seen during other periods, narrow markets eventually give way to broader participation among stocks and asset classes. As these charts reveal no one segment of the U.S. investment market has consistently outperformed another.  

Certainly, most of these charts pull us back to the late 1990s, which we have often compared the current period to. We have previously characterized the late 1990s as a late-cycle economy that kept chugging along due to Fed rate cuts following a tightening cycle in 1994/95. Secular themes of internet installation and adoption kept economic growth pushing forward, offsetting weakness in other areas. Corporate spending to fix the Y2K bug also helped. And toward the end of the cycle a narrow segment of stocks drove markets higher, while other stocks and asset classes languished.  

While this economic cycle has similarities, it is not identical. However, we believe the coming years could provide a similar market dynamic. We highlighted the short-term impact of earnings revisions earlier, but as the time horizon expands, overall valuations play an important role in shaping returns. While overall valuations are not yet as high as they were in the late 1990s, Small- and Mid-Cap stocks trade at similar discounts to their Large-Cap peers that sport historically heightened valuations. As a result, investors are increasingly gravitating toward what has worked while leaving behind those areas that haven’t despite these asset classes being historically cheap. The trigger that changed and broadened leadership toward U.S. Small and Mid-Cap stocks then was a mild recession that drove rates lower and shifted monetary policy. Perhaps this time the catalyst will not be a recession but rather simply the passage of time as companies and consumers adapt to still higher rates.  

This is where the concept of diversification, optionality and an appropriate time horizon remain critical inputs into our investment philosophy as we enter 2025. We continue to build broadly diversified portfolios that represent a balanced long-term approach to investing but have tilted our portfolio toward asset classes that should benefit when economic participation broadens over the intermediate term, either via a resumption of disinflationary trends that allows the Fed to cut rates more than investors currently expect in 2025, a mild slowdown that snuffs out lingering price pressures., or simply the passage of time. In either outcome, we continue to emphasize the value of diversification in the face of 2025’s uncertainties. Investment-grade fixed-income real rates are sitting near 20-year highs, and U.S. Small and Mid Caps are trading at relative valuation discounts not seen in decades. We think that tilts toward these asset classes help bolster diversification and optionality within portfolios as we look ahead to the new year. 

Frustratingly, it’s possible the narrowness of the market could continue into 2025, but we believe that intermediate- to longer-term investors should pay greater heed to the lessons of history and valuations. Economic seasons change and shift market leadership.  

The final word as we look ahead to 2025  

2024 is in the history books, and the uncertainty about market leadership in 2025 is high. Will mega-cap tech continue to significantly outperform? Will the Fed be able to continue cutting rates despite lingering inflation? How will the looming threat of tariffs translate into monetary policy? Are investors overreacting to stronger than expected data in the fourth quarter much the way they reacted in the second quarter? Is the ongoing AI infrastructure buildout sustainable? To be sure, there are other factors that will shape the economy in the year ahead, including a new administration in Washington and an ever-growing national debt, as well as possible geopolitical events that could produce short-lived volatility. Answers to these questions will likely have an outsized impact on capital market and macroeconomic performance. 

Uncertainty remains high, which brings us to a close with a conversation of risk. We believe that anyone who chooses to concentrate in any one part of the market is doing so based on their belief that they know what is going to occur and that history has no chance of “rhyming.” We don’t share this belief and note that history is littered with examples of new investment hypotheses that were viewed as certainties until they were eventually proven wrong. This is often true of companies, where current winners are often relegated to yesterday’s headlines as time passes.  

The dominant performance of mega-cap tech has driven record levels of concentration in the S&P 500. Today the 10 largest companies represent 38.5 percent of the 500 total companies in the index, far exceeding the 29 percent peak in the late 1990s. 

Consider this reality in the context of an investor whose “investment plan” calls for investing only in the S&P 500 and who is putting nearly 40 percent of their future in the hands of 10 companies that are correlated around the similar theme of AI. Perhaps that streak of performance will continue, but what if it follows a similar script to that of the late 1990s? This is where we remain optimistic about AI but believe that the benefits will likely shift from those that have spent the recent past bringing it to life to the companies that will use it to increase their productivity. This is much like the internet back in the late 1990s, when benefits shifted from the builders to the companies that used it to increase their productivity and ability to reach their consumers.  

Despite the near-certain narrative that many believe is in the cards for 2025, we believe that many twists and turns lie ahead. Given this uncertainty, we continue to believe investors should follow a plan that accounts for the unexpected. We believe the best approach to an unknowable economic outcome—particularly over the intermediate to longer term—is diversification. While diversification is often viewed as a defensive tool, we see it as an all-weather approach that allows investors to have exposure to asset classes that may perform well even as others lag. 

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