By Jamie McGeever
ORLANDO, Florida, May 11 (Reuters) - As the artificial intelligence boom accelerates, stock market concentration is reaching historic proportions – and not just in the U.S. where tech megacaps like Nvidia and Alphabet dominate. Increasingly, top-heavy indices are a feature of global equity markets, not a bug.
The rise of the "Magnificent Seven" U.S. tech giants has amplified equity market concentration. The top 10 U.S. stocks currently account for 33% of the overall market's value,
according to Morgan Stanley analysts, and 37.5% of the MSCI USA index.
It's even more extreme in some other tech-heavy markets. The top single stocks in South Korea and Taiwan – Samsung and TSMC – account for around 20% and 40%, respectively, of their benchmark indexes, Morgan Stanley figures show. In fact, these two companies alone account for a fifth of the entire MSCI Emerging Markets Index , which covers 24 countries.
So should investors be worried? It depends.
On the one hand, market concentration can help lift all boats on the way up, as we are seeing today. Average annualized U.S. equity returns in times of increasing concentration since 1950 have been notably higher than during periods of declining concentration, Morgan Stanley's team notes.
But it's the down leg that matters.
The current period of concentration is mostly tied to one theme: AI. This means the S&P 500 and Nasdaq – and a growing number of indices in Asia – have essentially become directional bets on the success of this nascent technology.
In turn, if earnings and guidance from just a few tech giants fall short of expectations, the top-down drawdown could be as indiscriminate as the rally, potentially turning into a disorderly rout, as battle-scarred investors know all too well.
And given sky-high AI expectations, a market correction need not require AI to flop. The technology simply needs to be less revolutionary than expected.
"PASSIVE CONCENTRATION TRAP"
If that occurs, where is the offset?
Investors in an S&P 500 index fund may think they are diversified, but this is mostly an illusion. As RBC Wealth Management analysts note, more than $40 of every $100 invested goes into just 10 companies. This "passive concentration trap" creates a feedback loop where fund inflows lift the biggest stocks and increase their weights, regardless of whether their fundamentals justify it.
Perhaps an inflection point is near. Analysts at RBC note that the market-cap-weighted S&P 500 is outperforming its equal-weighted counterpart by more than 30%, a historically wide margin.
"This evolution requires a recalibration of assumptions," they wrote earlier this year. "The index has been a resilient benchmark, but its top-heavy structure warrants scrutiny."
CONCENTRATE ON EARNINGS
Extreme concentration does not necessarily mean stocks at the top are overvalued, however, if the fundamentals of the top firms are also booming.
Look at U.S. earnings. The top tech stocks accounted for 53% of the S&P 500's returns last year, according to analysts at Goldman Sachs. And two-thirds of the projected $150 billion rise in first-quarter earnings this year are expected to come from tech and communications services, LSEG estimates show.
What's more, not all concentration is created equal. Narrow leadership will naturally be higher in an index made up of a relatively small number of companies, as is the case in Taiwan and Australia.
Investors may also consider dominant stocks in these small markets to be relatively low risk if they are global giants operating in all regions, as is the case with TSMC and Samsung.
It's also notable that there does not appear to be a clear link between concentration and volatility. When U.S. index concentration is historically high, the volatility of the index including megacap stocks is lower than without them, according to Goldman. For non-U.S. developed markets, it is higher.
LOOKING INTO THE FUTURE
Market concentration is increasing globally, and there is reason to believe this will continue – but that's not necessarily synonymous with rising risk.
In a world of greater fragmentation, a technological arms race and larger government footprints in business, more countries may start to have "national champions," companies backed directly or indirectly by governments.
Look at U.S. chipmaker Intel and its trajectory since the U.S. government took a 10% stake last August. Its shares have more than trebled in the last six weeks, taking its market cap to more than $600 billion from $185 billion.
Even if governments aren't taking direct ownership stakes, they may be less apt to crack down on market giants if they are concerned about whether their tech companies can compete with peers in rival countries.
Of course, the more top-heavy markets get, the greater the risk of a disorderly reversal. Properly gauging that risk may become increasingly challenging though, as the global economy appears to enter a new phase where the last century's rules no longer apply.
(The opinions expressed here are those of the author, a columnist for Reuters)
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(By Jamie McGeeverEditing by Marguerita Choy)
