The Risk Some Investors May Be Missing

In a light week of economic data, investors set aside the debate about interest rates and inflation, instead focusing on earnings and growth prospects for Nvidia, a member of the so-called “magnificent seven.” The major indices finished at or near record levels thanks in large part to a blowout earnings report from one of the seven companies that have been a leading force to the upside for the major indices over the past month and, for that matter, the last few years. We’ll leave it to others who cover individual stocks to weigh in on the earnings reports and growth prospects for these companies and instead look at the group in the context of how they fit with investors’ seeming willingness to take on concentrated risks.

As a result of last week’s gains for the magnificent seven, the group now constitutes 29 percent of the total value of the S&P 500. If you throw in the remaining names to round out the top 10 by market cap, the list accounts for 34 percent of the total value of the large cap index. That means on any given day, more than one-third of the S&P 500’s performance is driven by just 10 companies. In fact, today’s level of concentration exceeds that seen in 1999 during the dotcom bubble, when the top 10 names made up 26 percent of the S&P 500’s total value. It’s true that the magnificent seven appear to be successful, well-run businesses. For example, the profits generated by these seven companies add up to 20 percent of the overall S&P 500 index earnings. Despite the huge profits, the top 10 are trading at approximately 30 times expected earnings for the next year and make up 29 percent of the index market capitalization. Simply put, significant optimism about the future growth trajectory may already be priced into the stocks.

It’s not that the top 10 names are bad companies; in fact, it’s quite the opposite, but a lot of future growth may already be priced into the stocks. And history shows there are risks worth considering for the future of any company—including increased competition, shifting regulations, and changing economic growth trajectories. Indeed, longer-term studies that examine how the top 10 names perform in the year after their rankings show that, on average, they tend to underperform. That’s because during the run-up in performance, these stocks become expensive, and the law of large numbers makes achieving the same rate of earnings or revenue growth more challenging. The combination of high valuations and slowing growth often sends investors in search of other opportunities.

Let’s revisit the late 1990s, which was the last time the market was this concentrated, as investors were rushing into the largest names to capture what they thought would be unlimited growth. In the five years following 1999, the equal-weighted S&P 500 (i.e., every stock in the index receives the same weight) outperformed the market cap-weighted index (where concentration of stock is determined by market cap and heavily weighted to the top 10 stocks) by 7.5 percent per year. Small and mid-cap U.S. stocks outperformed by more than 11 percent per year. While we aren’t suggesting that we will see an exact replay of the way 2000 unfolded, we believe it’s worth noting the risks that come along with concentrating your portfolio in just a few companies or asset classes. 

We highlight these risks not as criticism of the individual businesses—in fact, we own many of them in the portfolios we manage; instead, we worry that investors are often tempted to follow yesterday’s winners at the expense of abandoning diversification.

As we’ve all been reminded repeatedly since the arrival of COVID, there are always unexpected events that ripple through the markets without warning. The future is never certain, and market leadership often shifts suddenly. Unfortunately for some, the switch occurs after they have shifted assets into the previous leaders. Interestingly, last week we were provided with another real-life example of this approach when Japan’s stock market, the Nikkei 225, finally eclipsed the high it first set in 1989. Back then, the index was the darling of investors with its meteoric rise during that decade. It hit 38,915 on December 29,1989, after starting the decade near 6,500. Investors flooded into the index, only to see it fall and never regain the previous high—that is, until last week, which is more than 34 years later.

The story from Japan is similar to what happened after the tech boom in the 1990s. It took the tech-heavy Nasdaq 15 years to pass the high that it hit on March 10, 2000.

Reminders of what were once thought of as sure bets that faded as unforeseen changes arrived are plentiful—from the previously mentioned tech boom of the late 1990s to rising oil/commodities, real estate and China/emerging markets in the 2000s. Throw in falling inflation and bond yields in the 2010s to the recent inflation and rising interest rates and artificial intelligence boom, and it becomes clear that the future is unknowable. The way we deal with uncertainty and risk is through diversification.

That’s the key benefit of diversification, and those who stick with it may be in a stronger position in the long run—especially given that markets are likely to continue to vary from one year to the next. If you feel you may be taking on unnecessary or unintended risks in your financial plan, we encourage you to reach out to your financial advisor. Remember, a smart investment strategy leads with a steady outlook and looks through an objective lens that incorporates valuations. It also considers where we are in the economic cycle and the forward path of monetary and fiscal policy and market structure.

Wall Street wrap

While Nvidia grabbed the headlines, economic releases out last week reinforced our view that the Fed will likely need to hold rates higher for longer if it wants to see inflation retreat sustainably to 2 percent.

Fed minutes highlight a cautious approach to rates: Minutes from the Fed’s December meeting show that while the Federal Open Markets Committee (FOMC) may be done raising rates this cycle, it is in no hurry to cut them. That’s because, according to the minutes, “risks around the inflation forecast were seen as tilted slightly to the upside.” The minutes were consistent with the message we’ve been hearing from members of the Fed over the last few weeks that while inflation has been trending lower, it is premature to declare victory. This stance was reiterated by Richmond Federal Reserve President Tom Barkin, who noted in an interview last week, “You do worry that when the goods price deflation cycle ends, you’re going to be left with shelter and services higher than you like it.”

Barkin, who is a voting member on the FOMC, said he is increasingly watching short-term inflation data instead of year-over-year readings to assess the trend in price pressures. As we noted in last week’s Market Commentary, those trends suggest that price pressures may be heating up.

Forward-looking indicators remain weak: The latest Leading Economic Indicators (LEI) report from the Conference Board showed that economic growth in the second half of the year may stagnate. The January LEI reading declined 0.4 percent after December’s 0.2 percent decline. The latest drop in the reading was driven by a drop in the number of hours worked in manufacturing and the inverted yield curve (an inverted yield curve often signals that a recession is coming). The reading is now down 6 percent on an annualized basis over the past six months. The six-month diffusion index (the measure of indicators showing improvement versus declines) came in at 60 percent. The Conference Board notes that when the diffusion index falls below 50, and the decline in the overall index is 4.2 percent or greater over the previous six months, the economy is in or on the cusp of recession. The most recent diffusion index marks the first reading above 50 since March 2022.

While we welcome the improving trend, the index continues to flash caution. In a statement accompanying the report, Justyna Zabinska-La Monica, senior manager, Business Cycle Indicators at the Conference Board, noted, “While no longer forecasting a recession in 2024, we do expect real GDP growth to slow to near 0 percent over Q2 and Q3.”

Business activity improves: U.S. business activity slowed in February but remained in expansion territory. The latest preliminary data from the S&P Global Composite Purchasing Managers Index, which tracks both the manufacturing and service sectors, indicates that the Composite Output Index reading dropped to 51.4 (levels above 50 indicate growth), down from January’s final reading of 52. The latest reading marked a two-month low for the index.

The report shows the manufacturing side of the economy continued to improve, with a headline reading of 51.5, up from January’s final reading of 50.7. Manufacturers also enjoyed a jump in new orders, which rose to a reading of 53.5, marking the highest reading since May 2022. Services remained in expansion territory at 51.3, but demand softened from the prior month.

Home sales rise: The National Association of Realtors reported that existing home sales in the U.S. increased 3.1 percent in January to a seasonally adjusted annual rate of 4 million units. On a year-over-year basis, sales of existing units are down 1.7 percent.

The inventory of unsold homes was 1.01 million units, up 2 percent from December. The median price for existing homes came in at 379,100 in January, marking the seventh consecutive month of year-over-year gains. Rising prices are likely to add to affordability issues for prospective home buyers. Additionally, if home prices continue to rise, it could reverse the trend of easing shelter inflation consumers saw throughout much of 2023.

Continuing jobless claims rise: Weekly initial jobless claims numbered 201,000, a decrease of 12,000 from last week’s upwardly revised figure. The four-week rolling average of new jobless claims came in at 215,250. Continuing claims (those people remaining on unemployment benefits) were at 1.862 million, a decrease of 27,000 from the previous week. The four-week moving average for continuing claims rose to 1.877 million, up 8,500 from last week’s upwardly revised figure and the highest reading since December 2021.  

The week ahead

Monday: The U.S. Census Bureau will release data on new home sales for January. We’ll be looking at this data to assess the impact of recent fluctuations in mortgage rates on demand for newly built homes.

Tuesday: The Conference Board’s Consumer Confidence report will come out in the morning. Given the Federal Reserve’s ongoing focus on the employment picture, we will continue to focus on the labor market differential, which is based on the difference between the number of respondents who believe jobs are easy to find and those who report challenges finding work.

We’ll be watching the S&P CoreLogic Case-Shiller Index of property values. Prices overall have moved higher over the past few months. We will be watching to see if home prices continue to rise, which could lead to higher inflation readings several months from now.

Data on durable goods orders for January will be released to start the day. We’ll be watching for signs that businesses are continuing to pull back spending in light of economic uncertainty.

Wednesday: The Bureau of Economic Advisors will release its first update to fourth-quarter gross domestic product estimates for the fourth quarter of 2023. Initial estimates came in much stronger than expected, and we will be looking for any significant changes to the pace of growth.

Thursday: The January Personal Consumption Expenditures price index from the U.S. Commerce Department will be out before the opening bell. This is the preferred measure of inflation used by the Federal Reserve when making rate hike decisions.

Initial and continuing jobless claims will be announced before the market opens. Initial filings fell last week, while the four-week rolling average of continuing claims rose. We will continue to monitor this report for signs of changes in the strength of the employment picture.

Friday: The manufacturing sector will be in focus as the Institute of Supply Management releases its latest Purchasing Managers Manufacturing Index. Recent readings have shown the sector perking up but still hovering around the flat line, and we will monitor it for any signs of expansion.

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