A bull market built on seven stocks

The S&P 500 has risen twenty per cent from its October low, which by the market's arbitrary convention makes this a bull market. Commentators are hailing a new economic dawn. Look beneath the cap-weighted index, though, and very few stocks are doing the work. A small group of large technology monopolies accounts for all of the 2023 gain, while the median stock in the index has gone roughly nowhere.

How the rally was built

The low came on 12 October, near the end of a year in which the Fed raised rates faster than at any time since the early 1980s. Two forces have driven the recovery since. Investors decided that the tightening cycle was nearly over, which lowered the discount rate applied to profits far in the future, and the launch of ChatGPT at the end of November turned artificial intelligence into the market's favourite story. Companies selling the chips, cloud capacity and software behind that story took most of the gains. Nvidia's market value briefly passed $1 trillion on 30 May, after it issued a sales forecast far above analysts' expectations.

Seven stocks, one index

Concentration of this degree makes the market fragile. Passive funds put money into companies according to their size, so they pile into the largest names automatically, and that has pushed valuations of the 'Magnificent Seven' to multiples that assume decades of flawless results. A rally that rests on seven balance sheets says little about the health of American industry. Investors are hiding in the companies with the most cash.

The seven are Apple, Microsoft, Alphabet, Amazon, Nvidia, Meta and Tesla. They share less than the label implies. Apple sells phones and services, Meta and Alphabet live on advertising, Amazon on retail and cloud computing, and Tesla on cars, while Nvidia's valuation now rests on demand for the chips used to train AI models. What unites them in the market's eyes is size, liquidity and a claim on the AI story, which means a single shift in sentiment can move all seven together.

The mechanics feed on themselves. A fund tracking the S&P 500 puts more of each new dollar into Apple than into the entire energy or utilities sector. As the biggest names rise, their weights rise, and new money follows them without anyone judging whether the price is right. Active managers who hold less of these companies than the index does fall behind their benchmarks, and the pressure to close that gap pushes them into the same stocks. Flows of this kind record demand; they carry no information about value.

Narrow markets have a history

Narrow leadership has preceded painful unwinds before. In the early 1970s the 'Nifty Fifty', large growth companies that investors regarded as safe at almost any price, traded at lofty multiples until the 1973-74 bear market cut many of them down. At the turn of the century the index leaned heavily on technology and telecoms shares, and after its peak in March 2000 the Nasdaq Composite lost most of its value over the following two and a half years. In both episodes the companies were real and many survived. The damage came from the prices paid for them.

Cash now competes with shares

The competition for investors' money has changed as well. For most of the past decade, with short-term rates near zero, holding cash cost savers money and pushed them towards equities almost regardless of price. Treasury bills now yield more than 5 per cent, so an investor can earn a real return while waiting. Paying a premium multiple for a technology giant makes sense only if its profits grow fast enough to beat that risk-free yield by a wide margin, and every further rise in the price narrows the room for error.

The case for the giants

The defence of today's leaders is serious. Unlike the dotcom favourites, these companies earn large profits, hold big cash piles and dominate markets that rivals find hard to enter. Part of their gain this year simply recovers the heavy losses of 2022, when rising rates hit long-duration growth stocks hardest. Narrow rallies also sometimes broaden later, as investors gain confidence in the economy and move into smaller, more cyclical companies. That benign outcome depends on a soft landing, which the Fed's own tightening makes far from assured.

The winners and losers from the concentration are easy to name. Holders of cap-weighted index funds have done well this year precisely because they own the leaders in size. Value investors, managers of equal-weighted or dividend portfolios, and anyone overweight in banks, energy or small companies have trailed badly. Pension funds and savers who believe they own a spread of American business in fact carry a large bet on a handful of technology firms and on a single theme.

Breadth is what would change the call. A catch-up by the equal-weighted version of the S&P 500, a recovery in small companies, many of them hurt by the regional bank failures and by floating-rate debt, and a rising share of stocks above their longer-term averages would show the rally finding wider support. Second-quarter earnings in July will test whether the leaders' profits can carry their prices, and the Fed's decision next week will show how much of the lower-discount-rate story survives.

An index that depends on seven companies for its gains behaves less like a diversified investment and more like a leveraged momentum fund. When those seven stumble, most likely on a disappointment in AI-related earnings or a Fed that keeps raising rates this summer, passive investors will find that they had far less diversification than they thought.