A top-heavy market may not be a warning sign, after all. I’m referring to the outsized share of the U.S. market reflected in a handful of megacap stocks. The combined market valuation of just five stocks — Apple Microsoft Amazon.com Alphabet (Google) and Facebook — currently represent more than 20% of the total of all companies in the S&P 500 index
Many believe that such a lopsided market isn’t healthy. They point out that, prior to the past couple of years, the peak of internet bubble held the record for when the five largest companies commanded the greatest share of the S&P 500’s market cap. That was when their share hit 17%, according to data from Morgan Stanley Research.
Any parallel to the top of the internet bubble is certainly alarming. But what is overlooked when drawing this parallel is that the world has changed in fundamental ways over the past two decades. What previously was a danger sign may now be the new normal.
That’s because the markets are evolving along with what’s known as a “winner take all” economy. I’m referring to a prediction made in 2005 in the Journal of Economics & Management Strategy by Thomas Noe of Oxford University and Geoffrey Parker of Dartmouth College. The researchers predicted that, because of so-called “network” effects in an internet-based economy, industries will become increasingly dominated by their largest companies.
Their prediction has been remarkably prescient. As I pointed out in a late April column, the percentage of total corporate profits coming from the 100 biggest earners has skyrocketed over the past three decades. In 1975, the profit share of the top 100 was 48.5%, and in 1995 was 52.8%. But by 2015 it had jumped to 84.2%. (These percentages come from research conducted by Kathleen Kahle of the University of Arizona and Rene Stulz of Ohio State University.)
With the recent earnings season now behind us, I decided to see what the comparable percentage was in 2020. It was higher still, at 91.8% — as you can see from the chart below. One third of the S&P 1500 companies lost money. The rest more or less were competing for the crumbs falling off the table from the profit feast of the top 100 companies.
In light of this, the lopsided U.S. market appears to be far less concrning. In fact, given how much the biggest companies are earning relative to the rest of the market, they deserve to have outsized market caps. According to FactSet data, for example, the five largest U.S. stocks as of June 7 represented 21.5% of the total market cap of the S&P 500, and their latest fiscal year’s net income represents 22.6% of the total net income of all 500 companies in that index.
Relative to earnings, in other words, the top five companies are slightly cheaper than the other 400 companies in the S&P 500. This is far different than the situation that prevailed at the top of the internet bubble, when some of the stocks with the biggest market caps were producing paltry earnings.
Dartmouth’s Parker said in an interview that it’s not particularly surprising that profits and market caps are currently correlated. It would be more surprising if they were not, as was the case at the top of the internet bubble. Absent such a disconnect, he said, the concentration of market cap in the largest companies “is not a signal of a top-heavy market.”
This doesn’t mean that the stock market isn’t vulnerable to a big decline, Parker added. The point instead is that, if indeed the market does decline, it will be for other reasons than the concentration of market cap among the largest companies.
Mark Hulbert is a regular contributor to MarketWatch. His Hulbert Ratings tracks investment newsletters that pay a flat fee to be audited. He can be reached at email@example.com