With history's longest bull market now in the rearview, passive investors are left highly exposed to an over-concentrated stock market that is on a collision course with a highly complex backdrop. Shifting macro cycles and heightened volatility across financial markets are only half the story, as investors and companies in a post-COVID world grapple with an ongoing geopolitical realignment and the increasing prospects of an economic recession.
Equity markets have been largely successful over the past decade at shrugging off several global economic and geopolitical events, including the COVID-19 pandemic. With optimism running stubbornly high and overall volatility subdued through late last year, stocks soared to meteoric levels, setting more record highs than any market watcher would care to count. For all the euphoria, however, these past 10 or so years have also been among the most challenging in history for actively managed large-cap growth strategies, as a mere handful of mega-cap stocks have increasingly led the broad market-cap-weighted indices higher (Figure 1). As active equity managers aim to avoid over-concentration, such consolidated levels of index leadership have wreaked havoc for those trying to avoid crowded trades and maintain portfolio weightings discipline. Simply put, managers have had to choose between giving in to a fear of missing out and potentially allowing for style drift, or running the risk of continued relative underperformance.
Figure 1. Today’s Russell 1000® Growth Index concentration has been steadily growing for nearly a decade
The combined weight of the top 10 largest stocks in the Russell 1000® Growth Index
Source: Bloomberg. As of 9/30/22.
As of September 30, 2022, the 10 largest stocks in the Index accounted for over 45% of total Index market capitalization, nearly double the level of concentration in the middle of 2014, when the pattern of leadership consolidation began forming.
This is especially so for those commanding a premium to outperform the Russell 1000 Growth Index (the Index): for the 10 years ending June 30, 2022 less than 20% of institutional, active large-cap growth managers outperformed the Index, according to data from eVestment. No surprise considering the Index recently exceeded concentration levels not seen since the dotcom bubble of the late 1990s. As of September 30, 2022, the 10 largest stocks in the Index accounted for over 45% of total index market capitalization, nearly double the level of concentration in the middle of 2014, when the pattern of leadership consolidation began forming.
Further to this point, the top five constituents of the Index account for a whopping 38% of the Index today, compared to only 17% a decade ago and 23% five years ago.1 The increase in concentration is staggering with many active managers carrying concentration-risk rules limiting individual maximum position size. A manager with a 5% maximum position rule is therefore automatically a minimum of 1,300 basis points (bps) underweight the combination of Apple, Inc. (AAPL), Microsoft Corp. (MSFT), Amazon.com, Inc. (AMZN), Alphabet, Inc. (GOOG/L) and Tesla, Inc. (TSLA). As shown in Figure 2, these five names combined—i.e. the “Big Five”—have accounted for more than half of the return in the entire Index over the past five years; being underweight this group has posed a meaningful headwind.
Figure 2. The “Big Five” have accounted for nearly 60% of the Russell 1000 Growth Index return for the last five years
Annual contribution to Index return last five years
Source: FactSet. As of 9/30/22.
Given these trends, fund flows in recent years show that investors have grown exceedingly uncomfortable with the premiums paid to large-growth stock pickers. Simply put, the opportunity cost for looking different from the benchmark has been too much for many investors to endure. However, there’s an embedded assumption in the inclination to transition away from large-growth active management: that market dynamics in the coming years will look similar, if not identical to recent ones. The proverbial question of whether trees can reach the sky comes to mind when considering how such a top-heavy index can continue to pressure active management, particularly in the large-cap growth space.
Rain clouds gathering as macro uncertainty quickly accelerates
While uncertainty is a core undercurrent of any market environment, the duration and magnitude of change today is unlike any other in history. Shifting macro cycles and heightened volatility across financial markets are only half the story, as investors in a post-COVID world grapple with an ongoing geopolitical realignment and the increasing prospects of an economic recession. Labor markets are tightening, inflation remains stubbornly high, the U.S. Federal Reserve’s tightening campaign grows ever more aggressive, all while supply chain disruptions continue to linger and the rate of company earnings growth is slowing. In addition, increased protectionism remains a material risk to future global economic growth and directly challenges the market opportunities for many companies, including the “Big Five”.
For example, the U.S.’s recently tightened export controls of semiconductor technology poses not only a direct challenge to those chip companies selling advanced products to China, but potentially to other companies with either a manufacturing or end-market footprint there. It remains to be seen whether this cat-and-mouse game escalates, but we believe it could erode considerable supply capability and/or end-market demand for many businesses with expectations of enhanced growth driven by their presence in China.
Getting Squeezed from Both Sides
Investors are now having to contend with “getting squeezed from both sides,” which refers to the two primary variables that influence equity prices—valuation and earnings. Over the course of 2022, the price-to-earnings (P/E) multiple on the Russell 1000 Growth Index has contracted from 31 times to 20 times by the end of the third quarter, accounting for the entirety of the Index’s decline this year. This is largely due to a sharp climb in the 10-year U.S. Treasury yield, which is the discount rate used by many investors to calculate the present value of a company’s future cash flows. Through the end of the third quarter the 10-year yield climbed from 1.5% to 3.8% as a result of meaningful inflation across the economic system (Figure 3).
The impact of the Fed’s tightening cycle, combined with geopolitical risks in Europe have more recently put pressure on earnings expectations.
We have found that higher multiple equities, often due to higher growth rates with more of their value in the “outer” years, tend to experience greater multiple contraction than those companies with lower valuation multiples when interest rates climb. This trend doesn’t take into account operating fundamentals of a business; simply that a rising discount rate may especially penalize the valuation of higher multiple businesses. At the end of the third quarter, many of the Big Five stocks were trading at a premium to the Index on a P/E multiple basis, including AAPL and TSLA, indicating that should rates continue to climb, these securities carry additional downside risk.
The impact of the Fed’s tightening cycle, combined with geopolitical risks in Europe have more recently put pressure on earnings expectations. Since the end of the second quarter, earnings-per-share (EPS) estimates for the Index for the third and fourth quarters have declined by 7% and 6%, respectively. This still assumes a 5% year-over-year growth rate for the third quarter; however, by the fourth quarter earnings are now expected to be flat year-over-year. This slowing growth doesn’t quite square with current consensus expectations of 15% earnings growth for 2023!2
There is clearly risk to forward earnings expectations, something that we’ll be watching closely during earnings season. Whether or not the Big Five are at greater risk to experience negative earnings revisions than other Index constituents remains to be seen. However, over the past few weeks we’ve observed that TSLA and AAPL experienced somewhat lower-than-expected deliveries (TSLA) and production rates (Apple iPhone) in the near-term. With both stocks at risk of multiple compression and negative earnings revisions given the potential for continued rate hikes and a more spend-thrift consumer, the trend of “the big just get bigger” may have reached its peak.
Figure 3. Macro factors taking their toll on equity valuations
As the primary discount rate used to calculate future cash flows climbs sharply higher, valuations are beginning to feel the downward pressure
Source: Bloomberg. From 9/30/12 to 9/30/22.
It’s impossible to know with any certainty when markets bottom or peak outside of hindsight. However, through observation it is increasingly clear that the concentration of the Index is at an extreme level today. It’s remarkable to consider that only five securities have accounted for 60% of the Index’s return over the past five years;3 and defines the albatross that has weighed on many active managers in the large-cap growth space. Many investors have followed the herd towards passive investing in the name of “if you can’t beat them, join them.”
It is clearly unpopular to go against the herd, particularly following a period when the herd has been right for many years. Yet, while the concentration of the Index could continue to climb, it would truly be unprecedented.
The Big Five are all businesses with meaningful scale advantages relative to smaller peers and have demonstrated impressive growth in a low interest rate environment. However, rising rates combined with a global economy continuing to grapple with the aftermath of the pandemic along with significant geopolitical risks may change the fundamental conditions on the playing field — whether in the form of increased competition, changing supply/demand dynamics or challenges to innovation. Time will tell whether the big continue to get bigger at the expense of other companies, or if the sky proves to be too lofty a goal for these behemoths to reach.
Sources: 1,2,3 FactSet. As of 9/30/22.
The views expressed are those of the author and Brown Advisory as of the date referenced and are subject to change at any time based on market or other conditions. These views are not intended to be and should not be relied upon as investment advice and are not intended to be a forecast of future events or a guarantee of future results. Past performance is not a guarantee of future performance and you may not get back the amount invested.
The information provided in this material is not intended to be and should not be considered to be a recommendation or suggestion to engage in or refrain from a particular course of action or to make or hold a particular investment or pursue a particular investment strategy, including whether or not to buy, sell, or hold any of the securities mentioned. It should not be assumed that investments in such securities have been or will be profitable. To the extent specific securities are mentioned,
they have been selected by the author on an objective basis to illustrate views expressed in the commentary and do not represent all of the securities purchased, sold or recommended for advisory clients. The information contained herein has been prepared from sources believed reliable but is not guaranteed by us as to its timelines s o r accuracy, and is not a complete summary or statement of all available data. This piece is intended solely for our clients and prospective clients, is for informational purposes only, and is not individually tailored for or directed to any particular client or prospective client.
Earnings per share (EPS) is a company’s net profit divided by the number of its common shares outstanding.
The Russell 1000® Growth Index measures the performance of the large-cap growth segment of the U.S. equity universe. It includes Russell 1000 companies with higher price-to-book ratios and higher forecasted growth values. The Index is completely reconstituted annually to ensure new and growing equities are included and that the represented companies continue to reflect growth characteristics. TheRussell1000® Growth Index and Russell® are trademarks/service marks of the London Stock Exchange Group companies. An investor cannot invest directly in to an index. Benchmark returns are not covered by the report of the independent verifiers.
Price-Earnings Ratio (P/E Ratio) is the ratio of the share of a company’s stock compared to its per-share earnings.
Market Capitalization refers to the aggregate value of a company’s publicly-traded stock. The Weighted Average Market Capitalization of a portfolio equals the average of each holding’s market cap, weighted by its relative position size in the portfolio (in such a weighting scheme, larger positions have a greater influence on the calculation). Weighted Median: the value at which half the portfolio’s market capitalization weight falls above and half falls below; Maximum and Minimum: the market caps of the largest and smallest companies, respectively, in the portfolio.
All investments involve risk. The value of the investment and the income from it will vary. There is no guarantee that the initial investment will be returned.