By Darius McDermott, managing director at FundCalibre
“Go big or go home” is one of modern America’s quintessential phrases. The land of the free is now a melting pot of some 330 million people, where everything seems to be growing by the day.
For example, the average new home measures 2,225 square feet, up 50% from 1,500 square feet in 1970, food portions in America’s restaurants have doubled or more in the past 20 years, while everyone also seems to be driving a monster car. They also have super sized supermarkets, with an average of 47,000 products to choose from.
As you’d expect, that size bias carries over to the stockmarket. With over 4,000 companies – the US accounts for more than 40% of the global stockmarket. But scratch beneath the surface and this is where the diversity ends – the reality is the S&P 500 is more concentrated than at any other time since 1999/2000 and before that the Nifty Fifties in the 1970s.
A very limited group of tech giants, Apple, Microsoft, Meta, Amazon, Alphabet, Nvidia, and Tesla – often wistfully referred to as the ‘Magnificent Seven’ – has been the power behind the S&P 500 for most of 2023. They comprise almost 30% of the market cap of the index, and have accounted for a significant share of its 13% return year to date. But is this narrow performance desirable or sustainable?
Maneesh Bajaj, manager of Brown Advisory US Flexible Equity, points out the ‘Magnificent Seven’ got a boost early in the year due to investors’ enthusiasm for AI, particularly after ChatGPT took the world by storm.
“This enthusiasm is largely well-founded, as these companies are strategically well positioned to capitalise on the advancement of AI. However, at the end of the day, how these companies drive earnings growth over the long term will be the biggest determinant of their stock prices,” he says.
An often-overlooked aspect in this discussion, Bajaj points out, is the strong rebound in earnings this year for certain companies within this group – namely Meta, Amazon, and Alphabet – following a challenging 2022 for these businesses. So this could be construed as more of a one-off than an indicator of earnings direction.
Premier Miton US Opportunities fund manager Hugh Grieves says having a significant concentration at the top of an index is not necessarily a terrible thing, particularly if all the companies are very different to each other, meaning there is still diversification.
“What is worrying for investors in the US today,” he adds, however, “is that the ‘Magnificent Seven’ companies look quite similar to each other, benefiting from similar halo effects and trading almost like one single super-stock. This gives investors very limited diversification.”
Common growth drivers, like AI, and the same markets, like Google and Facebook competing for advertising dollars, and Amazon and Microsoft competing for corporate cloud customers, leaves companies vulnerable to disappointment, Grieves points out.
At the same time, while investors may have been overhyped on the Magnificent Seven, capital has stayed away from the rest of the market, especially those stocks further down the market cap spectrum, opening up opportunities.
“This has left the valuations of US small and mid caps at historically low levels, providing an opportunity for an upward re-rating and decent earnings growth, providing the US economy avoids a full blown recession,” says Grieves.
Rupert Rucker, investment director for the Schroder US Mid Cap fund, agrees: “At some point there will be a rotation of capital but the catalyst is uncertain. However you can still invest in the US economy without paying a premium or suffering concentration risks by considering small and mid-cap companies.”
Smaller, more domestically oriented companies in the US are often better positioned to benefit from changing trends in the US economy, Rucker points out, and while the US consumer remains resilient, consumer spending is changing from goods to services, in a post-pandemic bounce back. He believes smaller company earnings are much more geared to services, which should further fuel favourable relative earnings growth.
Over much of the last decade, investing exclusively in the S&P 500 would have been the best decision. However, change is now underway.
“There are now good reasons for investors to broaden their allocations into small and mid-cap US companies that are more attractively valued and better positioned for a changing market environment,” Rucker says – and it’s also important to remember, given the size of the US economy, even ‘small’ US-focused companies are large by international standards.
Navigating the Magnificent Seven, or variations of it, is not a new phenomenon for US investors to have to deal with. Long-term stockmarket returns have typically been very concentrated; Hendrik Bessembinder found between at least 1926 and 2022 – when the US stockmarket return was driven by a few outlier companies – a large proportion of the market underperformed, with nearly 60% of stocks destroying wealth in that time.
Ben James, US equity strategy specialist on the team behind the Baillie Gifford American fund, is sanguine about the current iteration of this historical trend. He says they have been adding to Amazon and Meta recently, and have not trimmed Nvidia, “because the opportunity for ongoing growth, powered in part by the recent developments in AI, gives us confidence in the 2.5x return over the next five years from here”.
For some active managers, the narrowness of the S&P 500 rally in 2023 has presented an exciting opportunity. Fiona Harris, investment specialist on the JPM US Equity Income fund, likes tech, but also emerging secular growth catalysts within renewables, grid/infrastructure modernisation, healthcare, and energy, the best performing sector in the third quarter.
Harris sees the opportunity in the Magnificent Seven, but is not blindsided by it: “The key risk is getting caught in the middle of the AI stampede. That’s why we focus on high quality businesses with strong financial positions and solid fundamentals. Now is the time for certainty, conviction and balance.”