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Narrow market leadership- what’s the big story?

It is often said that putting all your eggs in one basket is a risky investment strategy. And that a diversified range of investments helps to spread the risk inherent in financial markets. Narrow market leadership, whereby a small number of constituent companies drives the direction of an index, could be viewed as the index equivalent, although not itself a deliberate investment strategy. We assess the rewards and the risks of narrow market leadership.

Although there are examples of other indices led by a particular sector, such as luxury goods for the French CAC 40, to illustrate the phenomenon we need look no further than the S&P 500 in the US. Move over FAANG stocks! Performance honours for 2023 belong firmly with the so called ‘Magnificent Seven’. The biggest tech stocks- Apple, Microsoft, Alphabet, Amazon, Tesla, Meta and now Nvidia- dominate the S&P 500, representing almost 25% of the index. And this handful of companies is pulling the entire index higher.

The Magnificent Seven have individually risen between 40-180% so far this year. These are huge companies and they have seen big rallies, increasing their dominance even further. Late entrant Nvidia has led the pack this year, adding $640 billion to its market cap. Nvidia makes the powerful semiconductors, or chips, required by artificial intelligence (AI) models such as Chat GPT. Each of these seven tech companies is exposed to AI to differing degrees.

Given the weighting of the S&P 500 index by market capitalisation, as huge amounts of money has surged into AI flavoured tech, any investor not on board with the big tech rally has seriously underperformed. Interestingly, the S&P 500 Equal Weight Index was recently in negative territory for the year. No wonder that this has been dubbed ‘the most hated rally’ in stock market history. And given the prospect of economic slowdown later this year, it’s hard to see how the other 493 stocks that comprise the S&P 500 can ever catch up.

So what could check the momentum of the Magnificent Seven? With inflation gradually coming under control, it’s unlikely to be any ramping up of the interest rate hiking cycle, which hit highly valued tech stocks last year. Nonetheless, if the hype over generative AI should start to cool, Nvidia could once again be viewed as a high-end chip maker, exposed to the same extreme fluctuations in demand as in the past. With high reward comes high risk and, with such narrow market leadership, any negative impact on one of these tech giants would be felt by the entire index.