Should investors worry about market concentration?
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A small number of stocks are driving most of the outsides gains in U. S. Equities this year. So is that a problem for investors? I'm also Nathan, and this is golden sex exchanges.

Each month, I speak with investors, policymakers and academics about the most pressing market moving issues for our top of my report from golden sex research. This month, I spoke to two prominent market waters who are an opposite size of this very relevant debate. David, costing our chief U.

S. Equity strategist in common sex research, believe that investors should be concerned about the high level of U. S.

Equity market concentration today. That's because he finds that high concentration is associated with lower returns over the longer run. But oh, on the moon, senior vice president and portfolio manager acadian asset management disagrees.

He says that current concerns about high U. S. Market concentration are over blow. I started off by asking my colleague, David coin, just how unusual the level of market concentration is today. He disgust two measures he uses to determine this, the share of total S P five hundred market cap accounted for by the top ten stocks and the market cap of the larger stock relative to the .

seventy fifth percent tile stock. One measure is easy for people to comprehend, understand, track, follow. What have you is the way of of the S M P five hundred and market cap that is contributed by the top ten stocks we have dated on back forty five years and we have date on daily basis.

You can actually look at IT very specifically. And the specific number is o top ten companies today comprise around thirty six percent of the market cap, and they go back over time around twenty percent. At the peak of the that com bomb in two thousand, IT was about twenty five percent.

And then we use another approach or time series that brought the data back one hundred years. Today, thirty six percent of the market gap is a top ten stocks. Using other metric we level that we've never seen before since one hundred and thirty two.

So how concerned should investors be about this high level of concentration today?

So a critical observation is that a high concentration market has information about long term fold returns, not necessarily need to return. So where you passing the question was how concern should they be about IT today? IT should be concerned about IT from a long germ investment perspective will take ten years as a long term measure.

So I didn't tell you what's the risk of the market in the next week or month or six months here. IT is informative about a long term return prospects. And one of the reasons is that valuation and concentration are two distinct variables.

They are not the same. They can be correlated at some points, but they are often times not correlate over time. They're not correlated by using concentration as a additional employment. Thinking about long term returns, it's an important variable.

So your question, how concerned should they be? They should be concerned because IT has impact on longer term turns into the high level of concentration today would suggest that the returns gone forder like to be lower than they might have otherwise been if you had a low construction market. Obviously, ter factual or looking backwards at the experiencing high constraint market is typically date lower return on forward.

So in our analysis, market concentration is a consistently reliable indicator of future returns.

Well, in our model is just a significant in terms of incremental adding value in explaining forward returns. What I mean by that is if you think about how to forecast longer to returns, the model books set a variety of inputs, vua being the most important informative variable about what the returns i'll like you going to be going forward. The draft ability of companies is another variable interest rate environment.

Today would be important. Information content about power returns and concentrations similar adds to the accuracy of our forecast so we can build model, including concentration as variable or we can remove that. And I think that's an important point to understand the typical annualize.

Can you return over any moving when to over last hundred years is one eleven percent. So you didn't know anything else. Historical experiences get eleven percent annualize told to return in the stock market.

The last ten years has been around thirty nine percent. So the next ten years, what do we expect? Our conclusion is, even if we don't include construction, we just use some of the other variables.

I imagine vision, interest rates, profani ability, economic growth, sumption, that would suggest your return profile and ten years is like to be bull. Low average. It's like real nine percent in our range midpoint, round seven.

However, when we incorporate concentrations are variable, that shifts IT lower because he does have the justice making our model more accurate by including IT. So that leads us to a conclusion of somewhere between minus one percent, the extraordinary low to seven percent, eight points around three. So a shift ago posed by around four hundred basis points. So from seven to three percent.

if you think about what's driving that unique market concentration factor that's weigh on that tenure average, what's the intuition behind why that drags on returns?

The intuition is with high concentration forward realized, the volatility is likely to be great. Her because it's a narrow group of companies driving index. Any profile, if you have a relatively few number of constitutes the return is going to be more violence tile than any broadly diverse fighting for.

And investors are not being compensated because evaluation is not attractive. The value for this expected higher realized value. And the reason we make that statement is the polar.

If you look at these leading stocks, they trade today with a negative risk premium. We have not seen that at all for twenty years at thirty one times earnings. For these companies, the inverse of thirty one times is about three point two percent as a learning yields.

Look at ten year U. S. Trade fields today is like four point two percent as a negative risk before you get a earnings, yelled that below the return and you can get on ten year treasury els. The rest of the market is creating A A positive test previous, in fact.

And then the second is these stocks that are driving that high concentration are trading at very high valuations because the expectation is their growth is going to be really, really elevated for a persistently long CAD of time going forward. These compounds expected up twenty percent growth going forward. But history shows that the number of companies that can actually deliver twenty percent growth, you have to, you have to, you have to ear face dramatically, and almost no companies can continue to do that over a decade.

So how might you be wrong? In other words, if IT turns out ten years from now that this argument was incorrect, that high concentration did not, in fact, drag S P. Five hundred return, where might you have gone wrong?

A place we can be wrong. And the first would be the idea of artifical intelligence being a contributor to more sustainable sales growth for these companies. And they continue to maintain in high valuations at number one risk.

And the second risk is when you forecast something out ten years, the constituents of the market, important observation, but about three and percent of the constituent of the index n over every gear, you were that out over a decade, and roughly a third of the companies give me new in the ten years. And so were forecasting something that is yet to be determined present time. So that's another source of potential risk.

And the third would be to extend that you have incremental household allocation to equities. That would be another potential source of demand. We think that's less likely because the allocation of household or folios to equities about fifty percent as the fed reserve data going back in nineteen fifty two, seven years, we are at the highest level that we've been because we have a more empty horizon investment culture for households. So you could make a case, maybe it's gonna to sixty percent strongly, a possibility. So I said there are three risk that could create a where return to be, rather, they are so many.

So what should investors do that?

We're not saying equities will generally do badly. We have a lower than average return for a capsizing waited index, but the typical stock is likely to give you a percent return, which has been an attractive return over history. So our argument is, look, if you going to be in the public actually market at this picture with the high concentration that were at right now, we would recommend on taxable investors ought to bearing an equated ted benchmark as opposed to a capable now we're forecasting on a senior horizon, the data in our model would suggest that IT is a Better way to invest eighty percent of the time over a ten year horizon and equating index is Better than a capital index a percent time.

Next, I spoke to portfolio manager or in the month, who sees all of this differently. I took the same approaches I did with costume and first asked him how concentrated the U. S. Equity market is today.

There are different ways to measure market constrained, but a simple ways. Just what is the weight of the top ten largest firms in the total market cap? So if you look at IT that way, as of today in the U.

S. Stock market, we're in the neither hood of thirty percent higher than that was nineteen ninety nine, but not as was in the nineteen fifty and sixty or the nineteen and thirty. So I would say it's within historical norms for the united states.

So that's the united states. You compared to other countries, the U. S. Is currently, and as always, been way more diversified and less concentrated than other countries.

So as of today, most countries in europe more concentrated than us by that metric. And in other countries around the world, like iwan in south korea, there is just one company that's twenty percent of the market. So compared to them were way less concentrated, way more diverse and historical.

Like a one point, there was one company that was seventy percent of the finish stock market. So compared to either historically or internationally, we're pretty well diversified. We're not alarmingly concentrate.

There is obviously so much investor concern today about this so called very high market concentration. So do you think that, that concern ant is just overblown?

I do think that concern is overblown, and it's a fact the concentration has gone up in the recent years, but it's not an alarming back. I think the driving reality is that the concentration of profits has gone up in the U. S.

In the past ten years. So the reason the us stock market and more customers because profits, i've been more concentrated, the simple as that, the reasons to be alarm would be a Prices got out of line with fundamentals. And that may be a small part of the story here, but the main part of the stories is just that the fundamentals got more concentrated at the percent of profits produced by the top ten firms has gone up.

So I would say that today's high stock market concentration is mainly just a mechanical function or mechanical by product. Of the backbeat make cap growth firms have had incredibly high profit growth in the past ten years, and that is the main story. The second story is that growth firms by cap tech firms are somewhat more ricks valued than they were ten years ago. Put those two backs together, and i've got a more concentrate market. So if you want to worry about something, worry about those things, don't worry about concentration.

But I think a lot of people perceive that, that concentration in markets increases the riskiness of markets. Is that trip I love .

to talk about that. okay. So I think that's confusing two concepts. One is when I choose what stocks to own, do I construct a concentrated portfolio? And there is definitely true that smaller number of mediums, a bigger weight into one name in your portfolio generally increases rest.

But when the market choose, its portfolio awaits that are more constituted. I don't think that increases risk. I don't think it's true, for example, that in the thousand nine hundred fifties, the stock market was way risker because IT was more concentrated.

The stock market was probably safer in the nineteen fifty, less about less risky. Here's the two places where risk come from. They other come from fundamental risk, economic risk or they come from Prices that move away from fundamentals.

And I don't think either of those are somebody necessarily increase because stock market concentration goes up. And let me give you an example. In one nine hundred and eighty four, the justice department caused A T N T.

The big man political phone company displayed up into seven stocks, seven baby bells instead of one big model. I don't think that increased or decreased the risk of the stock market change measured concentration. I don't think you necessarily made the market safer just because there were seven stocks were before there were one.

Also, many of these stocks just just take the stocks in the makes. Many of stocks are already super well diversified. They're doing different things, are doing streaming movies, they're doing e commerce, they're doing cloud storage. They're already pretty diversified. And if I take a bunch of very successful profile, pretty uncorrelated businesses and put them in one big stock and that talk has a lot of weight, that's no big deal.

Is there any relationship between market concentration and returns? I don't see .

a strong relationship historically between concentrated markets and subsequent performance. I must just take nineteen and ninety nine as an example. There was a big tax stock couple in one thousand ninety nine, peaking at two thousand.

And is also true that, that happened to be higher market concentration then. But the higher market concentration was not the causing effect. The caul mechanism was the market was expensive. There were butcher growth stocks that were super expensive. And IT doesn't really matter if there was ten growth stocks were super expensive or a thousand growth dogs or supervision sive.

The main thing to look at this value, I think there's lots of reasons to think you stock over value today like the value spread, which measures gross stocks being expensive relative to value stocks. And that's more of the measure of whether growth, doctor are Priced now the whole market, but maybe the symptom of the market going crazy, getting too excited. So there's lots of concerning methods to say, the market over, but I don't think concentrations one of those measures.

I think people who are focused on this idea that concentration and returns are correlated are looking at research that has shown that is very difficult for firms to maintain the outperformance and the profitability for sustained periods. So over time, that performance will determinate and returns will be lower in the future.

Is the true that when you have one or two big firms dominating the stock market, those one or two big firms subsequently do poorly? Yes, that is true is not because they're big relative to the rest of the stock market, is because they are expensive.

So it's true that expensive stocks, whether they dominate the stock market or don't expensive dogs do poorly, but because their fundamentals absolutely disappoint and because they are just expensive and the Price needs to go down related fundamental. So for those two reasons, we gently we call out the growth factor, the value effect is that value to well growth active is so just due to the fact that they are expensive, I would expect the largest dogs in the U. S.

Stock market to disappoint over time OK. So that's like a content through history. And maybe I shouldn't say it's a constant through history because one of the things that happened in the past ten years is the big growth dox ten years ago did well.

They didn't mean revert, likely used, do so that's one reason concentration has gone up is because the reasons that are historically unusual, big growth talks got even been bigger. But the stocks that were important to the U. S.

Economy thirty years ago are not. The stocks are important today. So I think thirty years from now, we will have all kinds of firms you've never heard of that are important, that are generating jobs and generating profits and generating value for shareholders.

And so IT is an inevitable part of american experience that we have creative destruction. We have old firms get smaller and new firms get born and they get bigger. So I think that's likely to happen.

That would be very surprising to me if the magnificent seven today are dominating the economy twenty years from now. So I am not concerned about individual firms doing poorly. That part of our system works interesting.

So do you have a forecast about what equity returns could be in the next decade?

sure. I think that there is one bad rock math we know, and that is things that are expensive generally have low subsequent returns. So I would say, based on the fact the U. S. Dog mark is expensive today, that it's gonna lower returns in the next ten years compared to the previous ten years.

So what else should investors be concerned about?

OK? So first of all, there are the obvious geopolitical concerns that everyone talks about, and those are big concerns. The second thing is A I. A I is this very important innovation and is at least as important as the internet was, and it's probably more important.

So if we think about the internet that was introduced the nineteen nineties, that had all kinds of implications that killed some firms like blacklisted IT, created some other firms, like some of the biggest firms today, could not exist without the internet, and IT greater this huge bubble in nineteen ninety nine. And looking forward, I see all kinds of upside and downside risk in A I. So I could imagine that one scenario is we relive the experience of one ninety ninety nine.

We have a huge A I boom or maybe A A I bubble. And maybe that already started, I don't know. So that's one scenario.

You could also imagine a scenario in which A I is so transformative that IT destroys the value of many existing firms, just like what happened to block cluster. But on the bigger scale and the whole stock market goes down. So to me, in the next five or ten years, when I look at the U S. Stock market, I C, tremendous upside risk and tremendous downside risk.

You know, it's really interesting because even though David and O N have opposite views on whether investors should worry about market concentration, they do agree that U S. Equities will likely deliver lower returns over the next decade. That in the previous one.

Let's leave IT there. Thank you for listening to this episode of golden sax exchanges. I am alan Nathan.

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