The S&P 500 (SNPINDEX: ^GSPC) has advanced 80% since 2019, and most of that upside came from a relatively small number of stocks. Apple and Nvidia alone contributed a quarter of the gains, and the Magnificent Seven accounted for half. Consequently, the S&P 500 has become increasingly concentrated. In fact, the 10 largest companies now account for 36% of its market value, which has never happened before.
Some experts expect the situation to end in disaster. Goldman Sachs analysts estimate the S&P 500 will return just 3% annually over the next decade due to its concentration and elevated valuations. That would be a sharp contrast to the long-term average of 11%. But other analysts are less worried due the fundamental strength of the Magnificent Seven, and history says concentration could be a good thing.
The S&P 500 has outperformed the S&P 500 Equal Weight index by 8 percentage points this year, due largely to strength across its most heavily weighted stocks. That matters because the S&P 500 has only beat its equal weight counterpart by at least 5 percentage points six times in the last 50 years, and strong gains typically followed in the subsequent year.
The S&P 500 is doing something it has only done 6 times in the last half century
The S&P 500 tracks the performance of 500 large U.S. companies that cover about 80% of domestic equities by market value. Due to its scope, the index is commonly regarded as the best barometer for the overall U.S. stock market.
Since 1971, the S&P 500 has outperformed the S&P 500 Equal Weight index (EWI) -- which includes the same companies, but at identical weights -- by at least 5 percentage points just six times: 1990, 1995, 1998, 1999, 2020, and 2023. The chart below shows the S&P 500's return during the next year.
|
Year |
S&P 500 Return |
|---|---|
|
1991 |
26% |
|
1996 |
20% |
|
1999 |
20% |
|
2000 |
(10%) |
|
2001 |
27% |
|
2024 |
21%* |
|
Average |
17% |
As shown above, the S&P 500 returned an average of 17% during the 12 months following years in which the index outperformed its equal weight counterpart by at least 5 percentage points.
So what? Assuming the S&P 500 is still at least 5 percentage points ahead of the S&P 500 EWI by the end of 2024, history says the index will return 17% in 2025. Of course, past results are never a guarantee of future performance, but there is another reason to expect strong returns in the S&P 500 next year.
The Federal Reserve recently cut its benchmark interest rate for the first time since 2020, and analysts expect rates to continue falling into next year. "Since 1980, five of the 10 best years for the S&P 500 happened when the Fed was cutting rates," according to Sarah Stillpass, global investment strategist at JPMorgan Chase.
Stock market concentration and elevated valuations are risks for investors
The S&P 500's performance is largely driven by a handful of companies. That concentration is certainly risky, but not necessarily a bad thing in this situation. The Magnificent Seven are some of the most fundamentally sound companies in the world. They achieved an aggregate profit margin of 23.5% in the June quarter, while the other 493 companies in the S&P 500 had a profit margin of 8.5%, according to JPMorgan.
Furthermore, the Magnificent Seven companies are growing earnings faster than the rest of the index, and Wall Street analysts generally expect that pattern to persist through next year, as detailed below:
- 2023: The Magnificent Seven reported earnings growth of 31%, while the other 493 S&P 500 companies reported a 4% decline in earnings.
- 2024: The Magnificent Seven are forecast to report earnings growth of 36%, compared to 3% for the other 493 companies in the S&P 500.
- 2025: The Magnificent Seven are forecast to report earnings growth of 18%, compared to 14% for the other 493 companies in the S&P 500.
Investors should be aware that valuations are elevated across the stock market. The S&P 500 trades at 26.7 time earnings, which is a significant premium to the 10-year average of 21.8 times earnings. Meanwhile, most of the Magnificent Seven command even higher multiples, such that the average valuation across the group is 42.5 times earnings.
Here's the big picture: A few megacap companies are carrying the S&P 500, but history says the index could return 17% next year as its most heavily weighted members build steam. However, many stocks are historically expensive, so any bumps in the road -- be it weak earnings results or worrisome macroeconomic data -- could send the S&P 500 into a correction or a bear market. Investors should hope for the best but be mentally ready for the worst.
