Right now, the US has a highly concentrated stock market. The top 10 stocks in the S&P 500 index account for nearly 28% of the total market cap of that index. That’s a little down from last fall, but it’s still near a 40-year record high level.
Why might this be a problem?
Well, historically increases in concentration like this have been the result of over-enthusiastic expectations of future growth prospects. The 1970s gave us the Nifty Fifty. The 1990s gave us the dot-com stocks. And so on.
I never want clients to invest speculatively, but periods where we’ve had a highly concentrated stock market have historically preceded the periods in which the risk factors identified by Nobel Prize winner Eugene Fama and professor Ken French have performed best.
To see whether this might still hold true, I examined the level of stock market concentration in the S&P 500 going back to 1979, and compared that concentration to the subsequent strong returns of small cap value stocks.
What this graph shows is that when the top 10 stocks in the S&P 500 occupy the largest share of the index, the returns of small cap value stocks have typically been higher than the returns of large cap stocks. In fact, since 1979, when the concentration was above 25% the smaller stocks outperformed by 10% or more per year over the next five years.
So, what should you do with this information?
First, NEVER make big changes to your portfolio based on any sort of prediction about the future. Markets are pretty efficient, and predictions are usually wrong. A highly concentrated stock market is not a reason to make a sudden and radical change in asset allocation.
Second, if you already have diversified your portfolio to include a healthy allocation of small cap value stocks I hope you can use this evidence to boost your confidence that you’re likely to reap the rewards of that diversification.
Third, if you have NOT built a well-diversified portfolio then take this as a warning that there is no time better than now to do so. I see many portfolios from prospective clients that allocate their equities ENTIRELY or almost entirely to large cap US stocks. This is NEVER a good idea, and it’s an especially bad idea now.
If you need some help making some changes, we can give your current portfolio a second opinion.