‘Only ten stocks really matter’, declared Robert Armstrong in a recent FT Unhedged newsletter. He showed that the returns on the 10 largest stocks have handily beaten the S&P 500 index over the past two years. Apple is closing in on a $3tn valuation. That’s larger than the GDP of India, France, the United Kingdom, Canada or Australia. Indeed, it is larger than the GDP of all but the four largest national economies in the world. At $2.5tn, Microsoft is not far behind. Following close on the heels, Amazon is at $1.8tn and Tesla at roughly $1tn (all market caps and returns are as of Dec 15, 2021). The top 10 stocks account for $12.5tn of market capitalization. That’s 30 percent of the market cap of the largest 500 companies, and 25 percent of the market cap of all publicly-traded American companies. The US stock market has never been this top heavy since at least 1992.
A portfolio that rebalances monthly to track the largest ten stocks has doubled in value since the beginning of 2020, even as broader portfolios that track large-cap stocks have increased by roughly 50 percent. The dramatic outperformance of the very largest companies is due to the structural changes that ensued in the economy after the arrival of Covid-19.
Indeed, zooming out reveals that this is a new development. For most of the past decade, the top 10 portfolio has underperformed more diversified portfolios of the largest US equities.
In fact, if we go back thirty years, we find that the top 10 portfolio usually lagged behind more diversified portfolios of large-cap equities.
The size of companies has been one of the most commonly used investment factors since the 1990s when Fama and French documented the existence of a premium associated with this risk factor. But here’s the kicker: smaller stocks are supposed to sport a risk premium over larger stocks. So, the recent outperformance of the very largest companies is not only not to be expected, but the order of expected returns is upside-down. Just how much premium the largest companies have commanded is documented in what follows.
Table 1 shows the mean annualized returns, volatility, Sharpe ratios, max drawdowns, tracking error and adjusted means for monthly-rebalanced portfolios of the largest US companies. The tracking error is the volatility of the difference between returns on the monthly-rebalanced portfolios and the market capitalization indices. Less diversified portfolios are harder to track, meaning that you may not, in practice, be able to match the returns on the index being tracked. The adjusted mean is the annualized mean return less the tracking error. You can think of it as a penalized expected return that accounts for the difficulty of tracking less diversified portfolios.
Over the past two years, the top 10 portfolio has returned 39 percent per annum, compared to 24 percent per annum for the top 500 portfolio. It has outperformed the latter portfolio even in risk-adjusted terms, sporting a Sharpe ratio of 1.32 compared to 0.90 for the latter. Adjusted means also show a robust outperformance: 38 percent vs 23 percent.
Over the past decade, the top 10 portfolio has returned 19 percent per annum, compared to 14 percent for the top 500 portfolio. The risk-adjusted performance is less dramatic: a Sharpe ratio of 1.0 vs 0.9.
But over a longer period, the premium at the top vanishes. Since 1992, the top 10 portfolio has averaged a 10 percent return vs. 9.5 for the top 500 portfolio. The Sharpe ratio of the top 10 portfolio is actually lower over this horizon: 0.51 vs. 0.52. The max drawdown is also painfully larger: 70 percent instead of 57 percent. And the tracking error is much higher, 3.7 percent vs 1.9 percent, with the result that the adjusted mean return is much lower: 6.4 percent vs. 7.6 percent. So, there’s no outperformance of the top 10 since George H.W. Bush was last in the White House.
What we have, in fact, is a brave new world dominated by the very largest corporations. The top heavy structure of the stock market is a testament to the unprecedented concentration of economic power in the very largest institutions of organized greed.
How long can this world last? We should expect at least some of the economic transformations induced by the pandemic to reverse as the pandemic fizzles out. But we cannot be certain of the degree of such a reversal. Indeed, the top-heavy stock market may be with us for awhile longer.
Thank you for the writing, here are some beginner questions.
Question 1: what are the correlation between top-heavy stock market, income, inequality, and exports? (call back to Turchin)
Question 2: what is the best indicator for measuring top-heavy stock markets (calibrated to 0 being lack of oligopoly, 1 being absolute monopoly)?
Down the rabbit hole:
This reminds me of the Nifty Fifty boom in the early 1970s. At that time, someone worked out that the P/E ratio of IBM relative to that of the S&P 500 as a whole implied that IBM would be soon be several times larger than the US economy.
But this is 2021. I suspect that the reason megacap stocks appear to be so overpriced now is because there is an implied put. There is a lot of uncertainty that would ordinarily be priced in, but markets know that whatever else happens, the Fed and the government will not and cannot let these companies fail.
In fact, it might even be said that there is another assumption underlying share prices, an assumption that laws and economic outcomes are rigged in favor of the megacaps. If enough institutions buy in, that prediction becomes a self-fulfilling prophecy.