Analyst Insight: The Problem With the Trillion Dollar Club
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On the 6th of May, 1954, Roger Bannister set a very important record. He had done what many thought was impossible and became the first human to run a mile in under 4 minutes — 3 minutes and 59.4 seconds to be exact.
This milestone was one that runners had been trying in vain to achieve as far back as 1886, yet once Bannister had crossed the finish line, something amazing happened. Just 46 days later John Landy ran the distance in 3 minutes and 58 seconds. A year after that, the time was beaten by three athletes in the same race.
In removing the mental shackles that surrounded this achievement, Bannister paved the way for a new age of athletics. He had made the impossible possible.
In August 2018, Apple became the first publicly-traded company to cross the $1 trillion mark after 42 years in operation. It took just two more years to reach $2 trillion. 16 months later it briefly crossed the $3 trillion barrier.
In that time between $1 and $3 trillion, Microsoft, Amazon, Google, Facebook, and Tesla all joined the four comma club, with the latter two falling below the line again since. The speed at which value has been created in just a few names has been nothing short of amazing. From an outlandish figure beyond any real comprehension (enjoy Emmet’s attempts to put it into context here), the word trillion has now become a very real part of our everyday lexicon thanks to six companies.
Their ascent to the trillion-dollar mark has captivated Wall Street for the better part of a decade, creating vast amounts of wealth and — concurrently — creating a stock market that is dominated by just a few names.
In fact, we are approaching historical levels of concentration in the major indexes. In this piece, I’ll try to elaborate on how we got to this point, what it all means, and whether our obsession with mega caps should be cause for concern.
Back to Basics
Let’s start with the basics. To understand why the major indices have been dominated by just a few names in recent years, we must first understand how.
This all comes down to their composition. Both the S&P 500 and the NASDAQ 100 are defined by the weighted average market capitalization of their components. Now, this sounds a lot more complex than it actually is. What this really means is that each stock in the index is given a weight proportionate to its market cap, divided by the total market cap of the index.
If a company is worth $10 million and the combined value of the entire index is $100 million, then that company represents 10% of the index, or has a 10% weighting. Extending this example, it becomes evident that the movements of our $10 million company will have an outsized influence on this index, compared to a $1 million company.
Weighted average indexes are considered to be stable. They are also viewed as indicative of the wider market, as larger companies have more of an influence than smaller ones. Looking at the third major index, the Dow Jones Industrial Average, it’s clear to see why weighted average is the preferred method.
The Dow is price-weighted rather than market-cap-weighted, meaning the influence of a particular stock on the overall index is deemed by its stock price rather than the market cap. The inefficiency of this system has been well known for years, but nowhere was it more evident than when Apple underwent a 4-for-1 stock split, immediately dividing the effect of the index’s largest company by four. It’s no wonder index investors forego the Dow in favor of the S&P or the NASDAQ.
So now that we know how the major indexes operate and how one company can have an outsized influence on their overall performance, let’s take a look at the composition of the S&P 500.
With roughly a $40 trillion accumulative market cap, the S&P 500 is a representation of the stock market as a whole. Its four largest companies — Apple, Microsoft, Google, and Amazon — account for more than $8 trillion in market cap, representing over 20% of the total index. When we talk about the NASDAQ 100, these same four companies account for almost 40%.
If we throw in the rest of the top ten of the S&P — Tesla, Facebook, Berkshire Hathaway, Nvidia, Johnson & Johnson, and United Health — we see that the big boys make up over 30% of the market. This is the downside of a weighted-average index, as just a few names can end up dominating the entire index.
So what does a top-heavy market like this mean for us investors?
If you’re like me and spent most of last year scratching your head trying to figure out why your portfolio was sinking while the wider market seemed to be doing just fine, this concentration at the top goes a long way to explaining why.
One of the fallouts of such a top-heavy market is the issue of ‘market breadth’ — this is the last definition I promise.
Market breadth is the relative change in advancing versus declining stocks — how many are going up compared to how many are going down. To take the S&P 500 as an example, if 251 stocks are going up on any one day, that would be positive market breadth and the inverse for negative. Confirmation is when market breadth and the index are going in the same direction, while divergence is when they start disagreeing.
Now it gets a little sticky when an index is advancing yet it has a negative market breadth. This indicates that a few stocks are dragging the market higher, yet the majority of stocks are actually negative — a sure sign all is not well under the hood.
Divergence like this is usually a precursor to a reversal on the horizon. Does this sound familiar?
“The 10 largest stocks by market capitalization account for 30% of the S&P 500 Index’s total value, and five — Apple Inc., Microsoft Corp., Nvidia Corp., Alphabet Inc. and Tesla Inc. — accounted for about a third of the index’s 27% gain in 2021. In short, if anything goes wrong with that handful of equities, as well as mutual and exchange-traded funds based on the broad market, everyone might be in trouble.
Since 1980, there have been 11 instances in which the market breadth narrowed as sharply as it did between April and October of 2021, according to Goldman Sachs Group Inc. The S&P 500 went on to generate below-average returns over subsequent one-, three-, six- and 12-month intervals most of the time.”
So not only have the big names come to dictate the market, but they now seem to be holding it at ransom, with indexes becoming completely reliant on the fortunes of a select few.
2021 will go down as a historically good year for the stock market. A 27% gain is an amazing return, more than any index investor could reasonably hope for, and yet many stock pickers — myself included — will have come out of it the worse for wear, wondering where they went wrong.
Big Tech or Bust
So how did we end up in this situation?
First and foremost, we’ve been lucky enough to witness the emergence of some incredibly high-quality businesses that have converged at the forefront of modern technology. Reverting to investors slightly more experienced than I, Charlie Munger stated of Google “I've probably never seen such a wide moat", while his partner-in-crime Warren Buffett described Apple as “probably the best business I know in the world.”
Probablies aside, that is some ringing praise from two of the greats, and there are similar streams of platitudes that fall at the feet of Amazon, Microsoft, Tesla, and even Facebook from analysts across the globe. These behemoths have built and extended their technological advantages and established pseudo-monopolies across the infrastructure of the internet.
Of course, where quality goes, investors follow. But there is more to it than just quality businesses. The emergence of Big Tech over the past decade has supercharged the market as a whole, providing a unique investment opportunity combining high-growth and relative stability.
The concept of a trillion-dollar growth stock is a new one, but how could you describe these companies as anything else?
Another contributing factor has been the evolving state of antitrust laws in the United States. According to the University of Baltimore, the fundamental goal of antitrust is now to protect consumers, not increase economic efficiency. Technology has enabled these companies to create software platforms that are monopolies or duopolies without charging consumers a red cent.
Think of iOS and Android, the app stores, Google Search, YouTube, Facebook, Instagram. Even Amazon Prime is priced comically low for the service it provides.
All of these platforms are free to use or cheaper than alternatives, and in so doing, the companies that operate them have amassed vast amounts of power in our day-to-day lives. The fact that we, the consumer, don’t have to pay for anything has allowed them to circumvent much of the anti-trust obstacles that past generations of mega-caps struggled with.
And yes, these days it doesn’t go three months without a CEO being paraded in front of Congress to answer for one thing or another, or the EU bringing forth another slap on the wrist, but this is all after the fact. They’ve already established their monopolies, regulators are just trying to put the toothpaste back in the tube.
What Happens Next?
Are we resigning ourselves to the fact that the wider market will forever be dominated by a few big names? That Big Tech will continue to extend its advantage over its subordinates thanks to its vast resources? Is the only thing that can save us now from another decade of domination breaking Big Tech up?
Well, no actually.
You see, while it might be tough to fight your way to the top, it’s even tougher to stay there. Amazingly, once a company reaches the heights of the top 10 largest stocks in the market, it has historically underperformed from that point on thanks to a myriad of reasons including increased competition, a slowdown in growth, and multiple compression.
That is not to say that there have not been outliers.
AT&T was one of the largest two stocks on the market from the 1930s to the 1980s, while General Electric and Exxon stayed in the top 10 for more than 80 years. Even Microsoft is into its fourth decade as one of the two largest companies out there. But, these are the exceptions, not the rule. The top of the hill is a tough place to stay — just ask Zuckerburg right about now.
It is human nature to think that we are going through historical times. Our brains are wired to be self-centered in such a way that right now is the be-all and end-all. As such, the fear surrounding current market concentration levels is making a lot of headlines, but we must remember, top-heavy markets are nothing new. Right now may be tipping the scale, but the rest of the market will catch up eventually, and that presents a very exciting opportunity for investors.
It’s hard to imagine a market without Big Tech as we know it at the fore. Nor is it safe to bet against them. However, who is to say that by 2030 there won’t be a new cadre of companies that have come to dominate?
We are standing at the precipice of a new technological wave that will be tough to comprehend for many. The emergence of wide scale applications of quantum computing, AI, machine learning, and robotics — even web3.0 and the metaverse — all lie in wait. I predict the companies that power this new wave of innovation will enjoy a similar ascent that Big Tech enjoyed in the 2010s, and we will definitely see the trillion-dollar club become a lot less exclusive, making the market a little less top-heavy along the way.
What was that line about high-quality businesses converging at the forefront of modern technology?