The Equity Market Demonstrates an Unusual Behavior Unseen in More than Half a Century, Potentially Indicating a Notable Shift in 2025
The S&P 500 (^GSPC -0.53%) has been reaching new heights recently, marking the third year of the ongoing bull market. However, not every stock is benefiting equally from this rally.
The impact of major tech companies on the S&P 500's value has been substantial over the past few years. Advancements in artificial intelligence (AI) and significant investments in this field have favorably impacted the leading tech companies with substantial financial resources. Consequently, the powerful have grown even more powerful.
Investors anticipate that the substantial AI investments will yield profitable results in the future, driving up the prices of these tech giants. On the other hand, companies lacking the financial muscle to invest heavily in AI or those less affected by AI innovations haven't witnessed the same level of valuation boost as the industry leaders.
Yet, there's a concerning sign hinting at a potential shift in the market dynamics. The rapid growth of the giants has far outstripped that of the other market players, a trend that might be nearing its end soon. And this phenomenon presents an opportunity for savvy investors.
An alarming sign for investors
The exceptional performance of big tech companies has resulted in the increasing dominance of a select few prominent winners in the market. For instance, the world's top three companies - Apple, Nvidia, and Microsoft - account for more than 20% of the S&P 500.
S&P Global employs an additional metric to gauge market concentration. It calculates the average market capitalization of the S&P 500 and compares it with the index-weighted average. The index-weighted average puts greater emphasis on companies with larger market caps. As market concentration increases, the ratio of the weighted average to the unweighted average tends to rise.
Currently, the ratio stands at about 10:1, surpassing any level reported by S&P Global dating back to 1970.
This could serve as an alarming sign for investors. Those investing in a conventional S&P 500 index fund might be underestimating their lack of portfolio diversification. Moreover, if market concentration begins to decrease (a pattern commonly observed in the market), investors could be bracing themselves for a period of relatively poor performance. Market concentration is considered one of the reasons behind Goldman Sachs' prediction of a decade of subpar market returns.
When will the trend reverse?
Predicting the exact moment when the market will shift away from the dominant tech players that have propelled the S&P 500 is unfeasible. However, the current high concentration of the market and potential economic factors might suggest a reversal may be imminent.
As the Federal Reserve raised interest rates and tightened the money supply, it accentuated the advantage big tech companies enjoyed in investing heavily to grow their businesses and advance in AI technologies. The opposite could become a reality in the future.
In September, the Fed introduced the first interest rate reduction since 2020, and this might be the start of an extended cutting cycle over the following years. U.S. money supply is already witnessing a rapid acceleration, a typical indicator of a reversal in market concentration. And this change may occur as early as the coming year.
The simplest method to invest in a trend reversal
Investors don't need to identify the best performers outside the S&P 500's dominant stocks if they're intent on minimizing their exposure to the market drivers behind this heightened concentration. Picking the best performers isn't foolproof - Apple, Nvidia, and Microsoft might continue to dominate the market for some time. Nevertheless, investors can reduce their exposure to the major companies and increase their investments in smaller S&P 500 constituents by buying an equal-weight S&P 500 index exchange-traded fund (ETF) such as the Invesco S&P 500 Equal Weight ETF (RSP -0.12%).
The Invesco S&P 500 Equal Weight ETF is the most convenient and cost-effective way to invest in the equal-weight index. Its annual management fee is 0.2%, and it avoids capital gains distributions since its inception. It equally distributes its investments across every constituent of the S&P 500, readjusting its portfolio quarterly in sync with the official index.
Over the long term, the equal-weight index has outperformed the market-weighted index. While the equal-weight index performs better during periods of declining market concentration and underperforms in periods of increasing market concentration, the former scenario is more likely if you think that the current level of concentration is unsustainable.
In conclusion, the last five to ten years haven't been kind to the equal-weight index. However, if you believe that the current trend is unlikely to persist, you might consider adding the Invesco Fund to your portfolio or adjusting your investment to include the equal-weight index.
Investors might consider diversifying their portfolio by investing in an equal-weight S&P 500 index ETF, such as the Invesco S&P 500 Equal Weight ETF (RSP), to reduce their exposure to the dominant tech companies. This strategy could potentially yield better returns during periods of declining market concentration, which some investors believe could occur due to the current high level of concentration in the market.
As the Federal Reserve continues to monitor economic factors and possibly initiates an extended interest rate reduction cycle, it could impact the dominance of the major tech companies and potentially lead to a reversal in market concentration. This shift could provide an opportunity for investors who seek to diversify their portfolio and potentially achieve better returns.
