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Hyperconcentration in the US stock market may be nearing a peak.

Against a backdrop of disappointing economic news, stock market volatility has flared in recent weeks, and AI-focused tech titans have sustained some of the sharpest declines. Days after reporting robust earnings growth, semiconductor giant Nvidia plummeted 14% in a week, resulting in a $406 billion loss in market value, the largest weekly loss in dollars for any company in history. Microsoft, Meta and Alphabet have also seen their shares swing from gains to losses since early August.

The jump in volatility follows an extended period of dominance for the Magnificent Seven, a group of megacap tech companies, six of which have businesses connected to AI. Since the start of 2023, four of these companies — Nvidia, Microsoft, Alphabet and Meta Platforms — have accounted for 43% of the total US market return as of 30 June 2024.

Whether news was good or bad, share prices for these companies only seemed to climb. Now one disappointing unemployment report can trigger sharp declines. “The sudden change in sentiment poses an important question for investors,” says Eric Stern, an equity portfolio manager. “Is a shift in market leadership going to become the dominant theme in the years ahead? Or will the Magnificent Seven stocks continue to generate the lion’s share of returns?”

High market concentration poses risks

Even after accounting for the summer volatility, market concentration in the S&P 500 Index remains at stratospheric levels. The 10 largest companies in the S&P 500 (which include the aforementioned tech giants) accounted for a stunning 34.2% of the total market capitalisation of the index as of 31 August 2024.

Market concentration has exceeded levels from the dot-com bubble

Investors may be surprised to learn today’s market concentration is considerably higher than the peak of the dot-com bubble in 2000. But any comparisons of today’s market leaders with those of the tech bubble in 1999 must be viewed in context. Although elevated, valuations for today’s tech giants are considerably lower than those of the previous period and supported by strong earnings growth. For example, Nvidia’s profit more than doubled from a year earlier to $16.6 billion for the quarter ended 31 July.

That said, high concentration can increase risk for investor portfolios. Today’s tech frontrunners can be vulnerable to regulatory risks, technological disruptions and the possibility that the path to AI profitability may be longer than expected.

“There is also some circularity to the Magnificent Seven earnings growth, because to some degree they are funding each other,” Stern says. Indeed, about half of Nvidia’s revenue in its latest quarter came from four companies.

Early signs of market rotation emerge

Even before the sharp market selloff in early August, there were signs of broadening market participation. A look at key style and geographic indexes shows that thus far in the third quarter, dividend payers, value companies and international equities all outpaced the broad S&P 500. And the MSCI EAFE Index, a broad measure of international stock markets, is far less concentrated than the US market.

Dividend payers and international stocks have shown recent strength

“The market environment had been telling us that only a few U.S. megacap companies were worthy of high valuations,” says Gerald du Manoir, an equity portfolio manager. “Yet there are many companies across industries in international markets with superior businesses, strong reliable cash flows and earnings growth potential. I think investors are starting to recognize a broader range of opportunity.”

For example, German software developer SAP, considered to have been left in the dust when US hyperscalers shifted to the cloud, has since made a successful transition to cloud and expanded its business by simplifying its offerings. “The market was skeptical that SAP could execute, but the company succeeded, and its customer adoption rate exploded,” du Manoir says. “Sometimes it’s the basic things that make a difference.”

Beyond the tech sector, companies like French jet engine maker Safran are tapping into rising global demand for air travel. The company also generates recurring revenue streams through services and maintenance contracts for the engines.

Focusing on earnings, cashflow and dividends

Earnings growth for many tech giants has been robust. But a look across market sectors shows surprisingly strong growth for several, relative to their own histories, some of which include companies with a history of paying dividends. Take utilities, which in the second quarter reported 21% year-over-year earnings growth, the highest growth rate among the 11 sectors in the S&P 500. The S&P 500 Utilities Index, a measure of the largest US utilities companies, gained 21% in 2024 to 9 September, outpacing the 14% gain of the S&P 500 and the 19% gain of the S&P 500 Information Technology Index.

Technology isn’t the only sector generating earnings growth

“I think we will continue to see this shift away from a very narrow US stock market,” says equity portfolio manager Caroline Randall. “I expect investors will increasingly focus on companies tied to long-term growth themes that generate near-term free cash flow and pay dividends. And with the US Federal Reserve planning to cut rates, we may be in the early stages of a renewed focus on dividends.”

For example, UK biopharmaceutical company AstraZeneca has invested heavily in research and development to address a wide range of cancers and cardiovascular and renal diseases. The company has a multi-decade track record of paying and increasing regular dividends.

Seeking out the market leaders of tomorrow

Will today’s tech giants continue to dominate, or will a new group of companies emerge as market leaders? “It would be difficult to discard the potential for today’s tech giants to remain on top,” Stern says. “But in the near term, all these companies are exposed to valuation risk as well as a variety of business risks. That’s why I am seeking balance in my portfolios and looking for opportunities across a broad range of sectors including technology, health care and industrials.”

For example, within the industrials sector, companies like aerospace components manufacturer and designer TransDigm have sought to tap into soaring global demand for commercial travel. Similarly, GE Aerospace, formerly a conglomerate with interests in media, energy and health care, has reorganized itself to focus on producing jet engines.

After all, the market leaders of today may or may not be those of the future. In fact, a look at the top 10 largest companies by market capitalisation at the start of each of the last four decades shows they often posted relatively modest returns in the subsequent 10 years. Are today’s megacaps destined to fall? “Not necessarily,” says Stern. “But I am focused on discovering the market leaders of tomorrow.”