US technology stocks are expensive. So what?

By PATRICK CAIRNS

A lot has been written this year about the performance of technology stocks. This is because of how Apple, Microsoft, Amazon, Facebook and Alphabet have dominated global stock markets.

For the first three quarters of 2020, just those five companies contributed almost 90% of the performance of the S&P 500. Amazon was up over 70%, Apple had gained 55%, and Microsoft was 31% higher.

These were already the biggest companies in the world, and they have just kept on getting bigger.

By the end of September these five stocks made up 21% of the S&P 500’s market capitalisation. That is almost double the average of 12.5% for the five biggest stocks in the US, and is the most concentrated that the market has been at any point in the past 30 years.

What next?

It is clear from the numbers that this is unusual. A lot of people have also worried whether it is sustainable.

As Pierre Debru, director of research at WisdomTree, recently noted:

“In the past, when the concentration at the top of the S&P 500 got very acute, the index ‘deconcentrated’ itself relatively quickly.”

He added that:

“Looking back at the last time the concentration at the top of the S&P 500 reached a similar height (i.e. the ‘dot-com’ bubble in 2000), the weight of the top five companies started to mean revert relatively fast. Six months after reaching 18.2% in March 2000, their weight was down in the 14%, still above the long-term average of course, but a lot closer to it.”

A look at history

Investors shouldn’t be surprised if this happens again. The reality is that the leadership of the stock market is always changing.

Bear in mind that Amazon was only listed in 1997. Through incredible levels of innovation, it has become one of the most important companies in the world in just over 20 years. In another two decades, who knows what new companies might have come along to displace it, in the same way that it has displaced the firms that dominated the market at the turn of the millennium.

At the end of 2000, the biggest stocks on the S&P 500 were General Electric, Exxon Mobil, Pfizer, Cisco and Citigroup. Today, only one of those – Pfizer – is still within the top 30. General Electric isn’t even one of the top 100.

Concentration risk

This may sound scary to investors tracking the index. Isn’t there a lot of risk in having so much allocated to just five companies, who, if history is anything to go by, are unlikely to remain so dominant?

The answer to that is both yes and no.

Concentration risk is a real consideration. Having a diversified portfolio is important, because you don’t want your entire investment to be derailed because just one or two companies under-perform.

There is, however, another side to this problem. Consider that anyone who bought an S&P 500 index fund 20 years ago is unlikely to be too worried now about the long-term under-performance of General Electric. Even though it would have been one of their biggest holdings two decades ago, the reality of the market has meant that its decline has been over-shadowed by the rise of others.

Winners and losers

This is how stock markets work. Research conducted by Arizona State University’s Hendrik Bessembinder on 80 years of US stock market history showed that, over their lifetimes, most shares produce a negative return.

That is a mind-bending fact, and one which highlights why stock pickers find life so difficult. But the corollary is one which index fund investors should find comforting – that stock markets still go up over time because of the performance of the few, very large winners.

Bear in mind that the most you can ever lose on a single stock investment is 100%. The potential gains, however, are unlimited. Consider that $10 000 dollars invested in Amazon when it listed in 1997 would be worth more than $12 million today.

That more than offsets the fact that General Electric’s share price has halved over the same period.

So, while investing in an S&P 500 index tracker will mean that you are exposed to expensive stocks that will potentially fall back over time, it also means that you will inevitably be exposed to the stocks that replace them. And that is what will ensure that your money keeps growing over time.