Stock market history is punctuated by dramatic periods of exuberant optimism (booms) and deep pessimism (busts). These cycles are characterized by a departure from rational valuations, often driven by herd mentality and speculative fervour. A hallmark of both booms and busts is the escalating concentration of a few dominant companies.
Market cap of the largest stock relative to 75th percentile stock (left side)
Weight of top ten stocks in S&P 500 (right side)
Major historical busts include the Great Depression of the 1930s, the Global Financial Crisis of 2008-2009, and the COVID-19 pandemic-induced market crash of 2020. During market downturns, investors seek perceived safety, gravitating to large, liquid stocks. This flight to safety exacerbates market concentration.
Notable booms encompass the "Go-Go Years" of the 1960s, the "Nifty Fifty" era of the 1970s, and the dot-com bubble of the late 1990s. Notably, the current market exhibits the highest concentration in US history, signaling a fourth major boom. The drivers of concentration vary across boom periods:
Go-Go Years (1960s): Fueled by rapid growth in emerging sectors like technology and electronics, this era saw a surge in speculative companies.
Nifty Fifty (1970s): Characterized by a focus on established, high-quality, large-cap companies with strong earnings growth and consistent dividends.
Dot-com Bubble (late 1990s): Driven by optimism surrounding the internet revolution, leading to rampant speculation in "Dot-com" companies, many of which lacked sustainable business models.
Current Boom (2018-Present): While artificial intelligence garner headlines, driven primarily by companies like NVIDIA, the extreme market concentration resembles the Nifty Fifty era where large established giants like Walmart and Costco are valued like market darlings.
Source: FactSet
A universal characteristic of all boom periods is the emergence of excessive valuations for a few large companies. As speculation intensifies, these companies gain disproportionate weight within the market indices, exerting significant influence on overall market movements. Apple, the largest company in the US, and Commonwealth Bank, the largest in Australia, currently account for 7% and 10% of their respective indices. Their elevated price-to-earnings (P/E) ratios compared to their benchmarks highlight their significant valuation premium for the largest stock in each index.
Source: FactSet
This trend of elevated valuations extends beyond these individual examples. The P/E ratios of the top 10 S&P 500 companies currently rival those observed during the Nifty Fifty bubble and are approaching the peak levels witnessed during the dot-com era.
S&P 500 Concentration Median P/E—Quarterly Data 1972 – 2024
Historically, boom-bust periods are short-lived and span several years between them. However, the current period of elevated market concentration is unprecedented in its duration. Prior to the current boom (Go-Go Years, Nifty Fifty, Dot-com), the period of increasing market concentration leading up to the peak typically lasted around 3-5 years. The current extreme market concentration that commenced in 2018, has now persisted for over 7 years.
A crucial factor contributing to this prolonged period of elevated concentration is the dramatic rise of passive investing, such as those into index funds and ETFs. The market share gain of passive investments at the expense of active managers has fundamentally altered market dynamics.
Money is pouring out of active funds into passive
US domiciled cumulative fund flows, $tn (to August 2022)
Source: JPMorgan
Two significant implications arise from the dominance of passive flows in markets:
1. Elevated market concentration and valuation
Passive flows, by design, do not discriminate between overvalued and undervalued stocks. This valuation indifference can perpetuate elevated market concentration and contribute to the persistence of overvalued conditions. This is evident in the highest market concentration and the longest-lasting boom in history.
2. Rolling booms and busts
While passive flows create consistent demand for stocks, prices are still determined by changes in marginal demand and supply dynamics for stocks by active managers. With fewer active managers, prices become more susceptible to self-reinforcing, rather than self-correcting, tendencies. An efficient market relies on the "wisdom of crowds" – the collective judgment of a diverse group often surpasses the insights of individuals. This phenomenon is akin to accurately estimating jelly beans in a jar through crowd sourcing.
However, this wisdom erodes when the crowd lacks diversity. In the current market, the convergence of active manager perspectives diminishes the “wisdom of crowds” effect and increases the likelihood of extreme market swings. Essentially, when all managers are "on one side of the boat," it's easier to inflate a boom, but it also increases the risk of a sudden and dramatic market correction. This is evident in more frequent mini boom-bust cycles in recent years: the boom that started in 2018, the 2020 COVID-19 bust, the 2021 speculative boom, the 2022 correction, and the current market boom. Active managers adhering to buy-and-hold strategies may struggle to navigate these rapid shifts in market sentiment. This is exemplified by the stark underperformance of growth managers in 2022 and value managers in 2024.
Conclusion
Historically, stock market booms and busts are quite rare, typically occurring over many years. However, the current market, dominated by passive investing, has fundamentally altered this dynamic. While passive investing offers the allure of simplicity and low costs, it has inadvertently fuelled a dangerous cycle of market instability. By indiscriminately allocating capital, passive strategies can contribute to the persistence of overvalued conditions during market booms.
Concurrently, the decline of active management increases the vulnerability of the market to experience booms and busts. The recent years have witnessed a disturbing trend of ‘rolling mini boom-bust cycles’, which serves as a stark warning. Just as night inevitably follows day, the current market exuberance is likely to be followed by a painful market correction.
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