An increasingly top-heavy S&P 500 is likely to get even more unbalanced as the five mega-cap tech stocks leading the index continue to grow, increasing the odds and potential severity of another collapse in U.S. equity markets, according to equity analysts.
The divergence has emerged as the S&P 500's five biggest stocks by market cap — Facebook Inc., Amazon.com Inc., Apple Inc., Microsoft Corp. and Google parent Alphabet Inc., or FAAMG — have markedly outperformed the rest of the index. Through July 24, the FAAMG stocks were up 29.2% on the year, compared to less than 0.3% for the rest of the S&P 500.
The FAAMG stocks now account for 22% of the large-cap index's total market cap, up from a 16% average in 2019 and the highest concentration by the top five stocks since at least 1980, according to S&P Dow Jones Indices data.
"When you see narrowing breadth and divergence between the performance of the much broader indices versus a handful of stocks driving the most-quoted indices, you have to take pause and you have to see that as a sign of fragility," said Peter Cecchini, founder of AlphaOmega Advisors.
The imbalance in the S&P 500 indicates that any rally in U.S. equities is likely unsustainable, Cecchini said in an interview.
"In order to become more bullish, you need to believe that the performance of those large-cap tech names is the result of something that should be dragging the rest of the indices alongside them," Cecchini said. "I tend not to believe that."
Unprecedented concentration
The FAAMG stocks' 22% share of the S&P 500's market cap far exceeds any top-five concentration since 1980, as far back as S&P Dow Jones Indices data goes. The previous highest yearly average concentration was in 1982, when International Business Machines Corp., AT&T Inc., Exxon Corp., General Electric Co. and General Motors Co. accounted for 17.4% of the index.
The historically high index weights of the top five companies leave the S&P 500 particularly vulnerable to any shock that drives some or all of the FAAMG stocks lower, economists with Goldman Sachs wrote in a July 22 research note.
"From a macro perspective, record concentration means the S&P 500 has never been more dependent on the continued strength of its largest constituents or more vulnerable to an idiosyncratic shock to any of these stocks," they wrote.
If the FAAMG stocks decline by 10%, for example, the bottom 100 stocks in the S&P 500 would need to increase collectively by 90% to keep the market trading flat, according to Goldman's analysis.
"I don't think it's a healthy trend," Michael O'Rourke, chief market strategist at JonesTrading, said in an interview. "I definitely have concerns."
Different than the tech bubble
O'Rourke compared the top-heavy concentration of the S&P 500 to the dot-com bubble, which peaked in March 2000, when Microsoft and Cisco Systems alone accounted for nearly 8% of the index's market cap.
But the concentration at the top is different now, with clear signs that the S&P 500 will only concentrate more at the top. Unlike in 2000, the largest stocks have shown above-average near-term growth, strong balance sheets, profitability, low leverage and other markers of "quality," the economists with Goldman Sachs wrote.
This concentration has likely been accelerated by the global pandemic and recession as investors have flocked to the mega-cap stocks in search of stability.
"People feel safer owning those names and that's why they're hiding in them to some extent," O'Rourke said. "These are obviously healthy companies; they're strong companies for sure. The problem is that just because something has a good balance sheet doesn't mean you should pay record valuations for it."
Investors have flocked to these mega-cap stocks also in part due to speculation fed by liquidity from U.S. fiscal policy, particularly since the Federal Reserve seems to act every time the stock market drops, Cecchini said. But the most recent rally in these stocks could be undone by a shift in that policy.
"I think people are baking in expectations of a pretty big fiscal policy stimulus package," Cecchini said. "If those expectations aren't met, that could challenge sentiment, and that could break those stocks first."
Analysts said other factors could also weaken the top-heavy S&P 500, such as increased tensions with China, which could further a trade war and decimate demand, or a victory by Democratic nominee Joe Biden in November's U.S. presidential election, which could increase corporate taxes and may lead to tougher federal regulation of these companies.
"Historically, if you look at the largest market-cap-weighted stocks, they almost never stay at the top of the index," said John Davi, founder of Astoria Portfolio Advisors.
S&P Dow Jones Indices and S&P Global Market Intelligence are owned by S&P Global Inc.