March 18, 2024

Many market indexes weighted by market capitalization are top-heavy right now. A glaring example is the S&P 500, where the “Magnificent 7” stocks account for roughly 29.0% of the index’s total value.

It’s interesting what has historically happened to stocks at the top of market indexes. Data shows it usually isn’t good. Consider how from 1957-2023, the 10 largest stocks in the S&P 500 underperformed the rest of the index by 2.4% in the year following their top rankings.

However, from 2013-2023 the 10 largest stocks in the S&P 500 outperformed the other 490 stocks by 4.9% in the following year. In 2023, the “Magnificent 7” beat the rest of the S&P 500 by a whopping 60.0%.

Of course, the largest stocks become the largest stocks through rising prices. This is mostly driven by multiple expansion and fundamental growth. But keep in mind that growth is more difficult to achieve when a company already owns a substantial share of the market in which it operates.

Also, the proportion of stock-specific risk in an index roughly matches its total concentration. So, the S&P 500 is highly vulnerable to problems at any of the “Magnificent 7” companies.

That should be concerning for investors since all seven companies rely on an ample semiconductor supply, spend huge sums of money on artificial intelligence, and are heavily exposed to China and Taiwan. Issues on any of these fronts could spell trouble for those firms. It could also hinder the entire S&P 500 since the “Magnificent 7” makes up so much of the index.

A top-heavy index, like the S&P 500 and its current “magnificent” concentration, could eventually topple.