DeepSeek sell-off shows concentrated US stock market risks

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present sale In the technology sector sparked by Chinese AI startup DeepSeek’s progress, this is a reminder of the risks associated with a concentrated stock market. The ten largest stocks represent nearly two-fifths of the S&P 500. This concentration is unprecedented in the modern era. Increasingly, equal-weighted index products, which invest the same amount of money in each stock in a benchmark index, are being promoted as a way to avoid the risk of an ever more concentrated portfolio. Should investors heed these calls?

More concentrated stock markets lead to less diversified passive portfolios. But this should not be a problem for returns or even for risk-adjusted returns. Having a third of your portfolio in a handful of stocks that compound their high returns has been great for passive investors in recent years, though less so for those active managers who have downplayed big tech companies.

There are good reasons why great companies are highly regarded. Today’s superstar companies capture global economies of scale. They create and control valuable intellectual property and have demonstrated the ability to commercialize it. Their profits have been growing rapidly and continuously. Market prices tell us that investors believe this trend can continue.

But the companies that are most valuable today are rarely the most valuable in 10 years. research Last year, Bridgewater Associates examined the performance of America’s most valuable companies dating back to 1900. By assembling a new group at the beginning of each decade and tracking their relative performance, the authors found that a market-weighted basket of the ten largest stocks had market performance below average. By 22 percent over the next decade. Turn the clock forward three decades, and this poor performance has extended to 53 percent.

This dynamic is healthy. Yesterday’s tech giants, like Eastman Kodak, Xerox, and Lucent, have replaced today’s Apple, Amazon, and Alphabet. The combination of spirited market competition and effective anti-monopoly mechanism is fundamental to achieving economic growth.

Today’s giant corporations are likely to be more successful than their predecessors at either reinventing and disrupting themselves to fend off competitors, or at stifling competition and seizing control of the government. But to believe that is to believe that this time will be different. For long-term investors considering products with equal weight indices, this is a big decision. A return to a less concentrated market requires weaker performance by larger companies. This is what is likely to drive outperformance by trackers of equally weighted indices.

No one can know whether today’s giant tech giants will maintain their presence in the market, or perhaps even grow. A year ago, the elastic band seemed tight. Since then, the so-called Big Seven have delivered an average return of more than 60% in 2024. To be sure, there is no foolproof quantitative model that predicts the future. So, like a lot of investing, it comes down to judgment.

Goldman Sachs published its call in October. In their judgment, index concentration will decline today, and the impact on long-term return estimates will be profound. The bank’s forecasting team, led by David Kostin, estimates that the S&P 500 will return just 3 percent annually over the next 10 years. With no change in index concentration, their call would have been a return of 7 percent per year. As such, their base expectation is for stocks to underperform US Treasuries – something historically rare.

One of the attractions of passive investing on a market cap-weighted basis is that it offers a free ride into markets made efficient by the analytical toil of active investors. Passive investors don’t need to look at the prospects of any individual company. By contrast, investing in an equal-weighted index fund implicitly rejects the idea of ​​an efficient stock market.

Equally weighted index products are a way to get exposure to US stocks without betting that this time will be different. They offer investors diversification, but they run the risk of missing out if the seven great companies continue their upward trajectory. As the late Charlie Munger once observed, “Diversification is for the investor who knows nothing.” His point was not that diversification was stupid, but rather that it undermined any ideas professional investors might have. Theory dictates that a know-nothing Munger investor would be best served by investing in a market cap-weighted index. For those who want to take advantage of the view that today’s extreme concentration will moderate, equal-weighted index products may be more attractive.