1st Quarter 2024: Market and Economy

Changing Story, Same Result

On the heels of a strong 2023, stock markets are off to a spectacular start this year. With a 10.6% return in the first quarter, the S&P 500 had its best start to a year since 2019 and is on a five-month winning streak.

Rallying at the end of 2023, stocks and bonds alike were rising on hopes for falling interest rates. Entering the year, the Federal Reserve was expected to cut interest rates by at least 1.50%. Three months later, the Fed is only expected to cut rates by half as much, largely because inflation has remained stubbornly stuck at around 3%.

Given the Fed’s tighter grip keeping rates higher for longer, bonds were down slightly. You might have also guessed stocks would fall as well—and yet the opposite has happened (much to our delight!). In large part, the robust performance reflects a resilient economy. In December, real GDP growth was expected to slow to about 1.0%–1.5% for 2024. Today, those estimates are closer to 2.5%. Another factor is the continued excitement around the potential for artificial intelligence (AI) to transform our lives, as well as the entire global economy.

Focused Concentration: Too Much of a Good Thing?

Since the lows of 2022, we have seen some dazzling returns. But when you take a second to dig deeper, the picture narrows considerably. Large-cap stocks have easily outpaced small-cap, mid-cap, and international equity returns. Even within large cap, it’s all about growth with the S&P 500 Growth Index up 33.8% over the past year, compared to just 25.6% for the S&P 500 Value Index.

Going even further, most of the gains within large growth come down to just a handful of stocks. Seven of the largest technology-driven stocks, dubbed the “Magnificent Seven,” have led while generating much of the AI hype. The Magnificent Seven is made up of Apple, Alphabet (Google), Amazon, Meta (Facebook), Microsoft, Nvidia, and Tesla. Collectively, these stocks have outperformed the other 493 stocks in the S&P 500 by an eye-popping 84% since the start of last year.

With their recent run, the Magnificent Seven stocks now make up 30% of the market capitalization for the S&P 500. To put that into perspective, the average weight for each of the remaining 493 stocks is a mere 0.14%. Talk about lop-sided!

We’ve seen investor views split regarding the rising market concentration. Some have seen the rise of the Magnificent Seven as an obvious result of the best companies capitalizing on the AI revolution, while other investors have become increasingly concerned about so few companies dictating the direction of the entire market. But before considering whether this level of market concentration is a recipe for success or disaster, let’s take a step back and ask: Is this really out of the ordinary?

Global Focus

To start, this is far from an American phenomenon. Granted, the US economy is a different animal, but international stock markets are even more dominated by concentration. Where the top ten stocks in the US represent 33% of the market, in France and Germany, the top ten names are 57% of the market.

Historical Reference

Looking back throughout the history of the US stock market, concentration is far from a modern phenomenon. We have always played favorites. Going all the way back to the late 1800s, railroads, the high-tech stocks of that time, accounted for over 60% of the US stock market. In the 1950s, energy and materials stocks dominated the market. In the 1960s and 1970, investors piled into the Nifty Fifty. In the 1990s, it was internet stocks. This isn’t our first rodeo. Clearly, market concentration is a feature of stock markets and not just a bug for today’s investors. And it also doesn’t last. Inevitably, market leaders fall out of favor and new stocks step up.

Time to Hit the Panic Button on the Magnificent Seven?

Today, concentration has risen to the highest level since the early 1970s. Add that to the current fervor around artificial intelligence and you can understand why we’ve started getting questions about whether or not we’re in a new bubble.

To start, the current market looks nothing like one of the more memorable manias in modern history—the internet bubble. In the 1990s, investors threw money at anything with “.com” attached to its name, despite the fact that many of those companies had little-to-no revenues, let alone profits. That type of concentration clearly wasn’t justified. While valuations relative to earnings may appear a bit extended today, they aren’t close to the heights seen in the ’90s or even as high as the post-COVID boom.

Also, the largest companies are among the highest-quality companies in the stock market. The Magnificent Seven are expected to account for 25% of the S&P 500’s earnings in 2024, generating earnings growth of 25% this year compared to just 8% for the rest of the S&P 500, according to JP Morgan.  The fact that companies with such high-quality earnings and strong balance sheets are leading today is reassuring given the recent run.

Also, rising concentration on its own does not create the conditions for a market bust. According to research by Goldman Sachs, stock concentration has peaked seven times over the past century and in five of those periods, markets continued to rise as concentration fell, including coming out of the financial crisis in 2009 and following the COVID recession in 2020.

Where Do We Go from Here?

When investing, the easiest way to get rich is to put all of your money into just a few bets. (It’s also the easiest way to get poor if you are wrong.) That would have worked very well over the past couple of years. Conversely, the best way to stay rich is to spread the risk by diversifying into hundreds or thousands of small bets. That way, the collapse of one stock won’t doom the rest of the portfolio. And diversification usually wins out in the end. It’s just a question of when.

There also may be signs of a sea change. The pace of rising concentration slowed in the first quarter with the broadest returns shown in March.

The outlook for interest rates, the economy, and earnings has shifted significantly over the past three months. The Fed has repeatedly reiterated that rates will only be cut when either inflation falls towards 2% or the economy weakens. Neither has happened yet, so we can’t say how long interest rates will stay elevated, which makes the outlook for stock returns uncertain as well.

The S&P 500 is up 25.4% over the last five months. A lot of optimism, in the form of investment dollars, has flowed into the Magnificent Seven. The market has a way of offering value in overlooked areas and history shows new stocks will rise and take the lead. We’re not saying the Magnificent Seven are going anywhere, it’s more that we just don’t know how everything will play out.

Railroads did change the economy the way investors expected in the late 1800s but it wasn’t just the railroads that made all the gains. Every company benefited from lower-cost transportation. Artificial intelligence offers the same transformative potential.

The question is whether or not the recent broadening of returns is the start of a new trend or just a short-term blip. Only time will tell. One thing is for certain in the stock market, change is the only constant.

This information is believed to be accurate at the time of publication but should not be used as specific investment or tax advice as opinions and legislation are subject to change. You should always consult your tax professional or other advisors before acting on the ideas presented here.