While the types of businesses most prominent in the market vary through time, the fact that a small subset of companies’ stocks account for an outsized portion of the stock market is not new. Moreover, research suggests these stocks’ best performance might be in the rearview mirror. The takeaway is that relying on well-established investing principles such as broad diversification helps ensure investors have exposure to a vast array of companies and sectors, potentially providing a more reliable approach to achieving their investment goals.
In 1967, the largest 10 stocks accounted for over 20% of market capitalization, and a marquee technology firm, IBM, was perched at No. 1. This sounds like a description of the current US stock market, dominated by Apple and the other FAANG stocks (Facebook, Amazon, Apple, Netflix, and Google, a subsidiary of Alphabet). Back then, however, IBM represented a larger portion of the market than Apple at the end of 2019 (5.8% vs. 4.1%).
As we see in Exhibit 1, it is not particularly unusual for the market to be concentrated in a handful of stocks. The combined market capitalization weight of the 10 largest stocks, just over 20% at the end of last year, has been higher in the past.
A breakdown of the largest US stocks by decade shows some companies have stayed on top for a long time (see Exhibit 2). AT&T was among the largest two for six straight decades beginning in 1930. General Motors and General Electric ranked in the top 10 at the start of multiple decades. IBM and Exxon were also mainstays in the second half of the 20th century. Hence, concentration of the stock market in a few large companies such as the FAANG stocks in recent years is not a new normal; it is an old normal.
Moreover, while the definition of “high-tech” is constantly evolving, firms dominating the market have often been on the cutting edge of technology. AT&T offered the first mobile telephone service in 1946. General Motors pioneered such innovations as the electric car starter, airbags, and the automatic transmission. General Electric built upon the original Edison light bulb invention, contributing to further breakthroughs in lighting technology, such as the fluorescent bulb, halogen bulb, and the LED. So technological innovation dominating the stock market is not a new normal; it is an old normal too.
Another trend attributed to a new normal is the extraordinary performance of FAANG stocks over the past decade, leading some to wonder if we should expect these stocks to continue such strong performance going forward. Investors should remember that any expectations about the future operational performance of a firm are typically already reflected in its current price. While positive developments for the company that exceed current expectations may lead to further appreciation of its stock price, those unexpected changes are not predictable.
To this point, charting the performance of stocks following the year they joined the list of the 10 largest firms shows decidedly lower performance results (see Exhibit 3). On average, these stocks outperformed the market by an annualized 0.7% in the subsequent three-year period. Over five- and 10-year periods, these stocks underperformed the market on average.
The only constant is change, and the more things change the more they stay the same. This seems an apt description of the dominant stocks atop the market. For investors, the implications may be that (1) a stock market concentrated in handful of stocks is not necessarily a reason to reevaluate one’s investment approach and (2) the lackluster performance of stocks after they reach the top of the market serves as a reminder of the importance of broad diversification.