Seven stocks, almost a third of the market

Apple, Microsoft, Alphabet, Amazon, Nvidia, Meta and Tesla now account for nearly twenty-eight per cent of the S&P 500's market value. The index is more concentrated than it was at the height of the 1999 dot-com bubble or in the Nifty Fifty era of the early 1970s, which puts some strain on the textbook case for diversification.

A year carried by seven

The concentration is the product of a single remarkable year. The group, nicknamed the Magnificent Seven, accounted for most of the S&P 500's gain in 2023, while the equal-weighted version of the index, which gives every company the same share, lagged far behind. Nvidia's share price more than tripled as demand for its chips for artificial intelligence exploded after the launch of ChatGPT in late 2022. Meta nearly tripled, and Apple became the first company to close with a market value above $3 trillion in June.

Index mechanics amplify the effect. The S&P 500 weights companies by the market value of their freely traded shares and sets no cap on any single weight. Each dollar that flows into an index fund is therefore spread in proportion to existing size, so the biggest companies receive the most new money. Rising prices raise their weights, which raises their share of the next dollar.

One index, seven bets

Millions of retail and institutional investors hold passive funds that track the index, and for them diversification now exists mostly on paper. Buying an S&P 500 fund today is largely a bet on technology hardware and cloud computing, with American business at large coming along for the ride. If valuations shrink or regulators crack down on these seven companies, passive investors will have nowhere to hide.

The seven are also more alike than their different products suggest. Microsoft, Alphabet and Amazon all sell cloud computing and are racing to build AI services on it, and Nvidia supplies the chips they use. Meta and Alphabet depend on advertising. All seven are long-duration assets, valued on profits expected years ahead, so they tend to fall together when bond yields rise, as they did in 2022, when several of them lost a third or more of their value.

Other indices have already acted

Concentration has forced changes elsewhere. In July Nasdaq carried out a special rebalancing of the Nasdaq-100 index, because the combined weight of its largest members had breached the limits in its rules; the weights of the biggest companies were cut and spread across the rest. The S&P 500 has no equivalent rule. Its investors hold whatever the market's valuations dictate, however lopsided.

What history suggests

Both earlier peaks of concentration ended badly for those who bought at the top. The Nifty Fifty were blue-chip growth companies, including Xerox, Polaroid and Avon, which investors in the early 1970s believed could be held at any price. The bear market of 1973 and 1974 cut many of them by more than half, and some never recovered. In 1999 the leaders were Microsoft, Cisco, Intel and other technology giants; after the Nasdaq peaked in March 2000 it fell by 78 per cent over two and a half years, and Cisco's shares have never regained their high.

Neither episode proves that concentration causes crashes. It shows instead that a market dominated by a few companies carries the risk of those companies disappointing expectations all at once, and that when they do, an index fund offers little protection.

The case for the giants

The strongest counterargument is that today's leaders are far more profitable than their predecessors. Cisco in 2000 traded at more than a hundred times earnings; the seven today mostly trade at much lower multiples, backed by large, growing profits and big cash piles. Their businesses are spread across devices, advertising, software, cloud services and chips. On this view their weight in the index reflects their weight in American corporate profits, and the market is simply recognising reality.

That argument has force, but it cuts only so far. High profits protect against collapse, not against a fall in valuations. If AI spending proves slower to pay off than investors expect, or if bond yields rise again, the multiples on these companies could compress sharply even while their earnings grow. Tesla, whose valuation rests more on expectations than on current profits, is the most exposed of the group.

Regulators are circling

The regulatory risk is not hypothetical. The Justice Department's antitrust case against Google's search business went to trial last autumn, and the Federal Trade Commission sued Amazon in September. A jury found against Google in December in its dispute with Epic Games over the Android app store. In Europe the Digital Markets Act has designated six gatekeepers, including Apple, Alphabet, Amazon, Meta and Microsoft, which must comply with new rules on app stores and data from March. Any of these could force changes to profitable business lines.

Winners, losers and what to watch

If the leaders stumble, investors in cap-weighted index funds and in technology-heavy growth funds would take the largest losses. Equal-weighted funds, value funds and those with more exposure to small companies and markets outside America would suffer less, and could gain if money rotated out of the giants. Pension funds that believe they own the broad market would discover how narrow their exposure has become.

The fourth-quarter earnings reports due later this month, especially guidance on AI spending and cloud growth, will set the tone. Rulings in the antitrust cases and the direction of long-term bond yields will matter as much. Fund flows deserve attention too, because the mechanics work in reverse: when investors pull money from index funds, those funds must sell in proportion to weight, and the largest companies face the largest sales.

The S&P 500 is no longer the diversified holding its owners think it is. A bad year for seven companies would now mean a bad year for the index, and passive investors would take the hit in full. The first real test will come the next time bond yields rise sharply or AI spending disappoints, and investors who want diversification will need to buy it outside the headline index.