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From the Desk of CIO Morning Star Marta Norton Shares What's Top of Mind: March 2024

Marta Norton
Chief Investment Officer, Americas
For General public Use

My Takeaways

  • Sure, we’ve seen concentrated U.S. stock markets in the past. But today’s levels are unusual.
  • Give the behemoths their due: Strong fundamentals drove their performance. We’re not convinced they will keep up this pace, though.
  • Our positioning? Proceeding with caution among the market’s favorites.

Chart of the Month

With the market’s largest companies on everyone’s minds, I’ve stumbled across a few articles suggesting that market concentration is nothing new. Does the historical data bear that out? Let’s take a look.

Exhibit 1: Percentage of Assets in Top 10 Holdings, 1974 — January 2024

Chart of the month

Source: FactSet and Morningstar Investment Management. Analysis selects the largest 10 companies from the 500 Index as a
percentage of the total security value of the SOP 500 Index. Data as of January 31, 2024.

Like most things, it depends how you look at it. Certainly, market concentration —as measured by the percentage of index market cap held in the 10 largest companies— has varied over time. At the start of our time series —in the early 1970s—that percentage was falling from highs near 30%. And while we didn’t quite return to those levels in 2000, we weren’t far off. However, the concentration among today’s top 10 outstrips both periods, topping 32% after climbing steeply over the past six years. In other words, for the first time in modern U.S. history, thirty-two cents of every dollar that goes into an 500 index tracker heads to the top 10 companies.

Exhibit 2: Largest 10 U.S. Companies by Market Cap

Source: FactSet. Data as of 1/31/2024.

It’s Not All Smoke and Mirrors

Give them credit; they deserve it. When we investigate the underlying fundamentals of the largest 10 U.S. companies, it’s clear they have simply out delivered the broader global equity market.

Before we dig into the numbers, a quick reminder: While stock prices bounce around daily, what drives
companies’ returns over longer periods is their fundamentals: their current distributions to shareholders (total yield, or dividends plus buybacks), earnings and expected growth (their potential future distributions), and, at least in the intermediate term, their change in valuation, or the price investors are willing to pay for them.

We’ve decomposed the returns for the current top 10 companies over the past six years, as their market cap has steadily climbed. Over that period, the behemoths returned 21.7% annualized, while the U.S. market broadly has returned 11.5%, and stocks outside the U.S. have generated 3.6%. While all return drivers contributed to the total return for the big 10, the lion’s share— 13.4%—came from the change in sales, or revenue. Contrast that with the broader U.S. market or stocks outside the U.S. While total yield has contributed more return for those markets, their change in sales was far more modest.

Exhibit 3: Return Decomposition, 2018 — January 2024

Source: FactSet, Morningstar Investment Management, Data as of Jan. 31, 2024.

Woulda, Coulda, Shoulda: What to Do Now?

Investing is a prospective game. We can’t capture—or relive— the returns that have already occurred. So here’s the question for today’s investors: Will we see the same dominant returns for today’s top 10 companies that we have seen over the past six years? First, some historical context. As one can conclude from Exhibit 1 —the market concentration graph— dominance has not tended to persist indefinitely.

But we’ve seen other sources of variability as well. For example, the drivers of equity returns have not been consistent over time, even for the market’s largest and arguably most competitive companies. To demonstrate as much, we constructed an index of the market’s top 10 companies in the 500, rebalanced monthly, and decomposed returns over rolling five-year periods from 1997 through January
of this year.

This period captures a range of market environments and a changing mix of dominant companies, And the primary drivers of return? Ever changing. Depending on the environment and the company makeup, we find margins, sales, valuation, and—in the recovery from the Great Financial Crisis—total yield driving the lion’s share of the top 10’s gains.

Exhibit 4: Five-Year Rolling Return Decomposition, 1997 — January 2024

Source: FactSet and Morningstar Investment Management. Custom Index created by selected the largest 10 constituents In the
SHP 501) Index and rebalancing monthly Data. as of Jan. 31, 7024

So, if history is any guide, at some point we should see the earnings outperformance of the top 10 companies fade to more normalized levels, with market concentration diluting as a result.

For this exercise, we compared analyst earnings estimates for today’s top 10 companies relative to the S&P 500 Index over the next five years. We then calculated returns, holding yield and valuations constant (an attempt at conservatism, since investors would likely bid the top 10 higher if they demonstrated such persistent outperformance), and calculated market concentration at the end of 2028.

Exhibit 5: Hypothetical Market Concentration Percentage of Assets in Top 10 Holdings in 2028

Source: FactSet, Morningstar Investment Management, Data as of 2/26/2024.

Yowzers. Should analysts prove accurate in their estimates, the top 10 companies will account for nearly 40% of the U.S. equity market at the end of 2028. And their aggregate earnings would be larger than the present-day earnings of all public companies in Europe. Possible? Sure. Probable? No.

Remember the Range of Outcomes

I’ve previously written that valuation isn’t a timing indicator, except at the extremes. As we start to
forecast improbable outcomes as the base case expectation, I’d argue we are getting closer to those extremes.

And don’t forget, there’s a cost to being wrong on these extremes. Consider what we’ve seen in the wake of prior periods of extreme market concentration. From December 1972 through September 1973, the Ibbotson Associates Large Cap Stock Index lost 43%. In the wake of the Internet Bubble —an arguably equally transformative technology to AI — that same large-cap index was down 45%.

Exhibit 6: Comparing Large-Cap Index Drawdowns Following Periods ot High Equity Market Concentration

Source: Morningstar Direct.

The Path Forward

Growing concern about market concentration and valuation risk doesn’t mean avoiding these top companies altogether. Timing is tricky, and the potential is there— however remote—that these companies continue to defy all expectations and ride A1 to the moon.

But risk management strategies can help. For the active subset, I’d argue individual stock selection is especially critical, That’s because, despite monolithic perception Of these top names, valuations vary company by company. Our investment team thinks that the more tech-heavy names that are closer to the AI narrative have benefited from more enthusiasm about their future earnings, but others, including those in the communications services sector, have far more approachable valuations. Thus, sorting among the subset allows investors to have some exposure to the market’s most dominate companies without taking on the same amount of sentiment risk.

For passive investors, index selection can help. A simple suggestion that’s made the rounds: Switching index construction from a market-cap weight to an equal-cap weight will reduce market concentration risk without sitting out the biggest names altogether. I shouldn’t hide the ball here: Moving from a  market cap weight to an equal weight amounts to a roughly 25% reduction in the largest names. A significant switch. For those leery of that kind of change in one fell swoop, introducing the equal-weighted index for new contributions, leaving the market cap index intact for already invested dollars, would help investors avoid exacerbating market concentration risk.

The Ides of March: Here Again!

Here we come: The long-anticipated March Fed meeting. As of December 29, the CME FedWatch Tool had probabilities of a cut at 88%. What a difference a few months and few hot(ter) economic prints can make! Today, cut expectations are near zero, with the market increasingly expecting the Fed to hold firm in May as well. We’ll be watching developments as closely as anyone else, but here’s the broader takeaway: Positioning portfolios for one particular outcome in mind—be it an expected recession or an expected Fed pivot—is a dangerous way to run money. It is far better to position portfolios for a range of outcomes, with an emphasis on consistency over winner-takes-all.

Until April!

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