The biggest keep getting bigger.
As of Friday October 8th, 2021, the six technology giants— Facebook (FB), Amazon.com (AMZN), Apple (AAPL), Netflix (NFLX), Microsoft (MSFT), and Alphabet (GOOG) —continue to dominate the S&P 500 index, accounting for a combined 25.0% of the total index.
Characterized by high growth with some risk, tech stocks have demonstrated tremendous profitability over the past decade as American digital dependency has proliferated through households, business, and commercial interaction. The latitude by which the amount of people are touched by technology continues to expand and these digital transformations have undoubtedly propelled this tech dominance. Analysts, on the other hand, are beginning to grow wary of the rapid growth. The S&P serves as a historically diversified asset, but with 25% of the index congregated in the tech market, can we really consider the S&P an evenly spread index?
With the S&P 500 relatively top heavy and tech heavy, it’s worth asking ourselves…
Do we still consider the S&P 500 a diversified-enough investment?
Does the potential tech sector size pose a risk for the markets?
Before critically reflecting on the relationship between tech dominance and diversification, it is worth taking a look at the S&P 500 alone as a measure of the stock market and American economy. The S&P 500 Index features the stock market index of largest U.S. publicly traded companies, weighted by market capitalization—the larger the market capitalization, the higher the percentage allocation. Institutional investors often prefer the S&P for its increased depth and breadth and mitigated risk, as opposed to the Dow Jones Industrial Average (historically associated with the retail investor’s gauge of the stock market). Because the S&P comprises more stocks across all sectors of the market (500 versus the Dow’s 30 industrials), many investors perceive the S&P 500 as a more accurate representation of U.S. equity markets.
Addressing the potential risk for markets, my response wouldn’t induce bearishness. The S&P 500 remains a darwinistic index by construction and as a byproduct, the companies have brought in growing market share. Despite tech increasing in market dominance, the industry built exists as a genuine creation. COVID-19 and the subsequent business changes —new customer behavior and needs, unpredictable demand, and huge spikes in working remotely—have propelled a rapid migration to digital technologies in all industries and sectors, and has ultimately accelerated global digitalization. Tech stocks have more than doubled in the past two years, making it the best performing sector in both 2019 and 2020. However, before 2017, technology remained more of an average performer, and often fell below other S&P sectors, like consumer discretionary, industrials, and communication services. The market share of FAANG and Microsoft has come to make up a significant portion of the notoriously diversified S&P 500, but, as I would argue, the dominance is rightfully so; tech dominance in the stock market was propelled by their unprecedented reach into our lives, shaping how we work, communicate, shop and relax.
With a quarter of the market cap heavily concentrated in 6 or 7 companies, how does this concentration affect risk of the market? To answer this question, we also must flip the question on its head and ask if there is investment opportunity for the other 75%? Whether you look at smaller valuation stocks or smaller capitalization stocks, there is undoubtedly opportunity out there. Opportunity affects both FAANG and the smaller market cap stocks out there. Take Tesla (TSLA) for example. This week TSLA held the 7th highest weight of market cap for the S&P 500. While this is an impressive feat for Elon Musk, it begs the question of where does TSLA plan to grow from there. Can they continue to push and gain more market overtime or will they fall down the line? And what about company #50? What are the respective growth prospects for the company ranked 50th for market cap concentration? It’s very possible the growth trajectory for the 50th company might be better positioned against the 7th, but regardless, the question of growth trajectory remains an important consideration when analyzing risk of tech dominance and opportunities for smaller valuation stocks to rise up.
While the risk of tech seems particularly heavy for the market, the S&P index is also an incredibly distinct asset for its fair balance in secular growers, cyclicals, and defensives. There are periods of time in the market where tech stocks come off, then all of a sudden banks come on, or banks come off then healthcare comes on. This see-saw-like activity creates a remarkably favorable asset for investors to mitigate the risk of the tech sector falling. Going forward, investors should be mindful of the concentration of risk and investment opportunities out there, but the incredible growth of FAANG and Microsoft is assuredly a credit to the companies strategy themselves.