Why mega-cap tech stocks’ dominance is a risk to investors

Investing in a stock index like the S&P 500 should, in theory, offer broad and diversified exposure to the market, helping investors to reduce their risk. But many investors are unaware of an issue that has made these kinds of passive investments much riskier today than they have been historically.

The stocks of just seven large technology companies - Alphabet, Amazon, Apple, Meta, Microsoft, NVIDIA, and Tesla - known as the Magnificent 7, have rapidly grown to dominate the S&P 500 Index. They currently represent about 30% of the index’s total market capitalization, a historically high level.

Buoyed by ultra-low interest rates for most of the last 15 years and recent enthusiasm around artificial intelligence (AI), these stocks have soared in recent years and, in 2023, accounted for nearly two-thirds of the U.S. equity index’s returns.

While there may be room for these mega-caps to rise even further, their outsized presence in benchmark indices like the S&P 500 creates risk for investors. Should even one of them tumble, it could deal a considerable blow to even a cautious investor’s portfolio.

Simply put, the more an index is concentrated in a relatively small number of stocks, the less effective it is as a tool for diversification. As a result, investors in such indices may see bigger-than-expected swings in their portfolios.

Investors who have exposure to the Magnificent 7 stocks via passive indices may be at risk for a few reasons.

• Close correlation to one another: All seven companies belong to the same technology sector, with overlapping business lines. In addition, their returns over the past year have been heavily driven by investor enthusiasm for AI. As a result, if investors sour on AI, or if one stock goes down, the whole group can fall—dragging down the value of the broader cap-weighted index.
• Interest rate sensitivity: When rates rise, these growth-oriented stocks are particularly apt to fall in value and vice versa. That’s because unlike with more value-focused stocks, their valuations are heavily predicated on future returns. We believe rates are likely to stay higher for longer than many investors expect, posing a challenge for the Magnificent 7. What’s more, their relatively high correlation with bonds, which also fall in price when rates rise, may reduce the diversification potential of stock-bond portfolios, such as the popular “60/40.”
• Sky-high valuations leave less room for gains: The Magnificent 7 are extremely pricey, with some investors believing these companies can remain profitable under many different economic circumstances. They sport a particularly rich average forward price-to-earnings (P/E) ratio of about 28, compared with the cap-weighted S&P 500’s multiple of around 20.

Given these risks, we believe the cap-weighted S&P 500 has the potential to disappoint some investors moving forward.

Our analysis shows that index concentration is rarely sustainable as it tends to rise and fall in multi-year cycles. An index can become increasingly top-heavy until a big macroeconomic event—like a recession or a change in the direction of interest rates—interrupts the pattern. This sparks an equity selloff that can cause the index to become less concentrated over time.

Importantly, this has implications for returns. Our study shows stocks tend to see higher returns when starting from a point of lower index concentration. They have far less favorable outcomes in periods of higher relative concentration—which is where we find ourselves now. Should the macroeconomic winds shift out of the Magnificent 7’s favor or their fundamentals fail to meet investors’ lofty expectations, these stocks—and the broader index—are vulnerable.

If these mega-caps do significantly decline and the indices become less concentrated, investors could expect increased volatility for the S&P 500 and other indices. In this scenario, our analysis suggests that:

• Broadly, benchmark indices for U.S. fixed income and non-U.S. equities would likely outperform the U.S. stock index. Consider countries like Japan, India and Mexico¹.
• Investors who want to maintain passive exposure to a U.S. equities index may want to consider the equal-weighted version of the index, which would likely be less affected by volatility among the largest companies. Investors should also consider stock-picking and active management in the short term.
• Investors may also want to consider “non-correlated” investments, such as hedge funds and real assets like gold, real estate, commodities, or energy to help further diversify their portfolios.

Source: ‘Consequences of Concentration’, a special report, January 19, 2024, Lisa Shalett, Chief Investment Office Officer, Head of the Global Investment Office, Morgan Stanley Wealth Management.

¹Morgan Stanley Research, Mexico is poised to ride the nearshoring wave, June 21, 2023