Is the stock market's advance too narrow?

Earlier posts have noted how uneven the advance of the US stock market has been of late. Since 2022, roughly half of the S&P 500’s two-fifths surge has been attributable to the ‘Magnificent Seven’ group, seven large stocks which are big innovators or users of technology. This is one of the narrowest US market advances we’ve seen – more so than in 2000, for example. Such concentration doesn’t sound good.

If these stock market gains reflect unfair competition in the economy, and the monopolistic abuse of market power, they could undermine the credibility of capitalism and even threaten its viability. Hence the existence everywhere of anti-trust laws and safeguards.

These rules have had teeth, starting perhaps with the US authorities’ break-up of Rockefeller’s Standard Oil in 1911. Telecoms company AT&T was forced to divest the Bell telephone system in 1982. More recently, three of the Magnificent Seven have faced substantial fines imposed by the EU authorities for anti-competitive practices. Sometimes the teeth are less visible but still potent – as when proposed takeovers and mergers are forbidden on competitive grounds.

But suppose – as we should – that most of the Magnificent Seven’s current strength is not a reflection of unbalanced competition or collusion, but is instead a reflection of technological circumstance and the evolving product cycle. In this case, its economic implications might be less worrying, as Magnificent Seven profitability will eventually peak, decline and be supplanted (as with Vodafone, Nokia, Cisco, AOL et al after 2000 – though Amazon, Apple and Microsoft were around then and are in today’s Magnificent Seven). If that is the case, how troubled should we be about stock market concentration per se?

The answer, as so often in finance, is frustratingly unclear. The investment syllabus has little to say about index concentration. In valuing individual stocks, or wider stock market indices, what matters is the likely profitability and riskiness of the businesses concerned, and the interest rates we use to discount those future profits – not how big the firm is, or how many names there are in the index.

If America Inc was the only quoted business in the US index (the S&P 1?), and the US authorities were somehow happy with that, its value on paper might be little different to the value of 500 equal-sized companies with the same product mix and earnings. If, as investors, we like what America Inc is making, and its prospects, should we care much how many distinct companies we have to buy in order to own it? Like capital structure, the scale of incorporation is another financial ‘veil’ that, as analysts, we look through. It’s what’s beneath that matters.

Analysts have often identified ‘conglomerate discounts’, in which a group of largely unrelated businesses seem to have been valued at less than the sum of their parts, and this has been attributed to the inefficiencies that centralised control might have introduced. But such conglomerates came into being to begin with because of investors’ earlier belief in the opposite, that is, in potential gains from agglomeration. Arguably the most successful investor today presides over just such a conglomerate, choosing not to get involved with operational decisions, instead providing subsidiaries with valuable continuity and funding efficiencies.

What about the need to diversify? It all depends. In practice, it has often been demonstrated that in order to mimic market-wide volatility you have only needed to own around 20-30 individual stocks, though when it comes to mimicking – or avoiding – extreme outcomes a recent paper has suggested you might need almost ten times as many (here). But genuine diversification comes from owning different business lines. The Magnificent Seven are not all doing exactly the same thing – and our notional S&P1 index owns all the varied businesses that comprise America Inc.

Nor is market concentration itself necessarily to blame for perceived problems with index or passive investing (about which, as we have noted, people seem to adopt needlessly polarised views: we are of course ‘active’ managers ourselves, but can see a role – and an audience – for passive investing too). The Magnificent Seven’s relative success cannot be the product of passive index-chasing investment, by definition. But nor does their existence make such investment any more likely to deliver especially good or bad long-term returns. If you buy the index, you will own them, yes – but that has not hurt so far, and you buying the index cannot somehow have been responsible for them beating the index.

More generally, people sometimes argue that there is in fact an ‘optimal’ size of business, and that in the context of economic development, for example, a region might do better if it had more ‘mid-sized’ enterprises. Indeed, some companies have surely become too big to be effectively managed, while uncountable others have struggled to achieve escape velocity from start-up.

But there is little evidence correlating a ‘right’ size with business success, and even if there were some, cause-and-effect would be difficult to identify. The popular example is the existence of the ‘Mittelstand’, a tier of mid-sized (and, by the way, largely bank-financed) businesses held responsible for much of Germany’s industrial success. ‘Our problem’, we are told, is that we have no Mittelstand. But its existence could simply reflect local history and circumstances, and may have no wider significance than that – in other words, it’s a German thing, not a scale thing. And are other regions less successful because they have fewer mid-sized businesses, or do they have fewer mid-sized businesses because they are less successful?

None of this means that, from our top-down vantage point, we positively embrace the lumpiness of the US market’s recent advance. And we are aware that such lumpy returns are not confined to the US market. But so far at least we have been relatively unfazed by it – and as with so many other issues, we suspect it may be less important than the next few twists and turns in the business cycle. Indeed, if economic growth does continue to show signs of bottoming out, that cycle, not a market reversal, may yet deliver a broader advance.

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