Written by LGT Crestone Head of Public Markets Todd Hoare
Year-to-date, the S&P 500 index has risen 13%. However, most of these gains have been driven by ‘narrow leadership’, with five stocks responsible for around two thirds of the gain, and 10 stocks accounting for around 85% of the index’s return. Historically, periods of narrow leadership, where a small number of stocks are responsible for most of the index’s gains, have been viewed as a pre-cursor to broader equity market weakness. However, there are many examples of where narrow leadership has not presaged a market sell-off.
In this Special report, we examine evidence that suggests that narrow leadership alone is not a reason to sell the market. Current elevated US valuations appear vulnerable to the impact on earnings of higher interest rates. However, during these periods of narrow leadership, investors might be better served to focus on ‘earnings’ leadership and breadth, as well as looking at other divergences, such as small caps versus large caps and value versus growth.
So far in 2023, five stocks have been responsible for around two thirds of the S&P 500 index’s gain, while 10 stocks have accounted for around 85% of the net overall gain.
So far in 2023, five stocks have been responsible for around two thirds of the S&P 500 index’s gain, while 10 stocks have accounted for around 85% of the net overall gain. Until the start of June, only the technology and technology-related sectors (including FAANG) were up on the year, with the remaining eight sectors negative. As of 1 June 2023, the equal-weighted S&P 500 index had been flat year-to-date, before taking part in the rally over the past several weeks.
In terms of the make-up of the MSCI US index, the top five companies account for more than 21% of the index, the highest proportion in more than two decades. And just over 40% of the MSCI US stocks have delivered positive stock price returns in the last 12 months, despite the overall index advancing more than 20% over the same timeframe.
Historically, periods of very narrow leadership have been viewed as a pre-cursor to weaker overall equity markets, although the evidence is not as clear-cut as this. Equity markets often fluctuate between periods of narrow and broad leadership, as we have witnessed over the past nine months and as shown in the table below. Furthermore, narrow market leadership is not a new phenomenon. In fact, over the past seven years, there has been a clear trend of markets becoming narrower, not broader, as can be seen in the chart below.
Historically, periods of very narrow leadership have been viewed as a pre-cursor to weaker overall equity markets, although it is not so clear that markets do weaken when leadership is narrow.
Period | Top 10 attribution | Everything else | Total S&P 500 return |
| Since Oct 2022 lows | 53% | 47% | 20% |
| Year-to-date | 85% | 15% | 15% |
| Since collapse of Silicon Valley Bank | 68% | 32% | 14% |
| Since NVIDIA’s upgrade | 64% | 36% | 6% |
Source: Bloomberg
Although the market was as narrow as it is today in August 2020, this did not presage a broader market sell-off. Instead, the rally broadened out to include more stocks.
This does not mean that there are not lessons to be garnered. For example, the last period of such extreme divergence between the S&P 500 and its equally weighted alternative was August 2020, which coincided with the US Food & Drug Administration (FDA) approving the Pfizer-BioNTech COVID-19 vaccine. Although the market was as narrow as it is today, it did not presage a broader market sell-off. Instead, the rally broadened out to include more stocks. In effect, investors had been ‘hiding’ in a small number of stocks and the vaccine amounted to a ‘regime change’, allowing the broader market to rally.
Conversely, in December 2021 we witnessed the reverse, and the narrow leadership of the S&P 500 index gave way as interest rates rose and valuations began to unwind. The result was 12 months of significant outperformance of the equally weighted S&P 500 versus the market-cap weighted S&P 500.
More recently, NVIDIA’s artificial intelligence (AI)-fuelled profit upgrade has reignited the debate on the predictive power of narrow stock leadership. Research from Société Générale strategists found the impact of the ‘AI-boom’ stocks on US equity performance has been so strong that the S&P 500 would have been down year-to-date if those stocks were excluded, while the 30% year-to-date rally in the Nasdaq (which is a growth proxy index) would be more than halved if monitored on an equal weighted basis. Moreover, if we removed the top 20 AI-boom stocks, the S&P 500 index would have fallen 2% this year, not gained 8%.
Analysis from Citigroup found that narrowing leadership alone is not a reason to sell the market. However, it did note that volatility typically increased when leadership narrowed.
Research from Barclays, an investment bank, would seem to corroborate these observations. It recently focused on a what it coined the ‘Leadership gap’ – that is, the spread between S&P 500 returns and the returns of the S&P 500 without the top 10 stocks contributing to the rally. Over the last three months, this leadership gap has widened more than 7%, with the top 10 performers accounting for all index-level gains. Over the past 30 years, there have only been two comparable instances of such narrow stock leadership – the 2000 Dotcom Bubble and the COVID-vaccine rebound of 2020.
Barclay’s research found that in both instances, “the top 10 stocks driving the rally retraced against the broader market in the short term. However, the longer-term trajectory of the top 10 leaders was dependent on fundamentals: the leaders collapsed in 2000 because multiples significantly overran the profitability/viability of the underlying businesses, whereas in 2020 the leaders delivered on earnings expectations and grew into their valuations.”
Analysis from Citigroup found that narrowing leadership alone is not a reason to sell the market. However, it did note that volatility typically increased when leadership narrowed.
Instead of selling the market based on narrow leadership, investors might be better served focusing on ‘earnings’ leadership and breadth, rather than share price, as well as what can be gleaned from other divergences, such as small caps versus large caps, and value versus growth. Until recently, the market had been displaying similar traits across styles, although over the past month, we have seen a reversal of sorts, with small caps outperforming large caps. For now, this seems to reflect investors’ appetite for laggards, as opposed to any fundamental change in the outlook for equity markets.
More tellingly, the price/earnings (P/E) multiple for the technology sector is now back to its highs of the past 20 years and the relationship between technology and real interest rates suggests that investors are ignoring the headwinds that come from higher rates (both in terms of valuation and broader economic growth). This underpins our current tactical positioning, which is modesty underweight US equities.
Investors have now priced out the ’Fed pivot’ that we believe has supported markets over the course of 2023. Indeed, investors are seemingly taking the optimistic view that one of the fastest monetary policy tightening cycles in history will not only deliver much lower inflation, but it will do so with little to no economic damage. While there remains a path to a soft landing and a more positive backdrop for equities, from current elevated valuation levels (in aggregate and even excluding the top 10 stocks), investors might be better served with a more cautious approach, or indeed an approach that reallocates the extended gains seen in the narrow part of the market to more attractively priced opportunities in other segments of the market (e.g., healthcare, consumer staples and energy). Indeed, even domestically, there are opportunities to reallocate not only within ‘expensive defensives’ (e.g., infrastructure and consumer staples) but also within capital structures (e.g., from bank equity to bank debt).
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