To The Moon

Three Stocks Now Account for 20% of the S&P 500's Value. That's Making Some Investors Nervous.

One Wall Street veteran makes the case for looking for value outside of megacap stocks.

For the first time dating back to at least 2000, three U.S. stocks - $Microsoft(MSFT)$  , $NVIDIA Corp(NVDA)$   and $Apple(AAPL)$   - account for more than 20% of the value of the S&P 500, Dow Jones Market Data show.

This means just three stocks in the index are worth more than hundreds of other constituents combined, according to data from Bespoke Investment Group.

And although there is some historical data showing that rising concentration typically coincides with stronger returns for the $S&P 500(.SPX)$  , the rapid run up in value seen by a handful of the biggest stocks is starting to make some investors nervous - even some who had been, until recently, relatively bullish.

"Strength in Nvidia and other megacaps has masked weakness in many other areas of the market," said Katie Stockton, founder of Fairlead Strategies, in a report shared with MarketWatch on Thursday. According to Stockton, small caps, midcaps and the $Dow Jones Industrial Average (.DJI.US)$ - along with the equal-weighted version of the S&P 500 XX:SP500EW - are all showing signs of deterioration.

Examples of this abound. Just look at the ratio of the small-cap-focused $Russell 2000 Index (.RUT.US)$ with the S&P 500, a measure which tumbled to its lowest level since 2001 earlier this week, according to FactSet data.

Or the divergence in relative price between the equal-weighted S&P 500 and its cap-weighted peer, which has grown more extreme as the equal-weight index has underperformed again this year. The ratio between the two recently touched its lowest level since 2009, according to analysts at $Bank of America(BAC)$   Global Research.

As high as concentration is for the S&P 500, it is even higher in the tech-heavy $NASDAQ 100 Index (.NDX.US)$. As of Wednesday's close, Microsoft, Nvidia and Apple comprised 41% of the Nasdaq-100's value for the first time since November 2023.

In both cases, the fact that so few stocks have contributed so much to the indexes' advances has become a frequent complaint expressed by bull-market skeptics. Many believe that if the rally were to fizzle out, it would be because stocks like Nvidia, which have driven an outsize percentage of the S&P 500's gains since early 2023, suddenly stop climbing.

As Nvidia crossed the $3 trillion threshold and surpassed Apple as the second-largest U.S. stock on Wednesday, those concerns appeared to manifest once again.

In an X post that went viral, Richard Bernstein Advisors illustrated with a chart how the percentage of S&P 500 stocks beating the index has remained unusually low in 2024, at about 30%, according to FactSet data. The S&P 500 is up 12.2% this year to date as of Thursday's close.

The last time so few stocks outperformed the index for two years in a row was 1998 and 1999, around the peak of the dot-com bubble, RBA pointed out.

Investors would be hard-pressed to argue that the current market environment is similar to the dot-com era. The dominance of the largest stocks largely reflects earnings and sales growth that dwarfs what other companies have seen.

But the market is, of course, forward-looking, and skeptics question how much longer companies like Nvidia can keep up their breakneck pace of growth. After all, semiconductor companies have proven to be extremely cyclical in the past, RBA's Richard Bernstein said during an interview with MarketWatch on Thursday.

Nvidia likely won't be able to continue surpassing Wall Street's expectations for earnings growth forever, or even much longer, which is why Bernstein believes the company's shares are likely overvalued. At the same time, investors likely haven't given shares of other members of the large-cap index enough credit.

FactSet estimates project that the 10 largest stocks in the S&P 500 will likely see earnings-per-share growth slow during the second half of the year, while the rest of the companies in the index, in aggregate, will see an acceleration.

Bernstein noted that there are already more than 160 companies in the S&P 500 that saw their trailing 12-month net income increase by 25% or more in the first quarter of 2024 - far less than the rate seen by Nvidia, but stronger than many other megacap names, including Microsoft.

Bernstein believes this is setting investors up for a dynamic where the "Magnificent Seven" and other megacap stocks pull back while the rest of the market rises. Investors have seen shades of this already, as shares of Apple and $Tesla (TSLA.US)$ have struggled in 2024.

He has also been encouraging investors for months now to look for bargains in other corners of the global equities market, like U.S. small caps and emerging-market stocks. Analysts expect both areas could see a boost once the Federal Reserve starts cutting interest rates.  

"It's like a seesaw," Bernstein said. "There are seven stocks on one side, and everything else in the global equity market is on the other side. Which side do you want to be on - not for the next 10 minutes, but for the next 10 quarters, or the next 10 years?"

"I think you want to be on the other side of that seesaw," he added.

The S&P 500 and Nasdaq Composite finished with marginal losses on Thursday as gains in consumer-discretionary, energy and consumer-staples stocks helped offset losses from Nvidia and other semiconductor names.

The Dow Jones Industrial Average finished higher, bolstered by surging shares of $Salesforce (CRM.US)$, which had slumped after reporting earnings last week.

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