The "Magnificent Seven" Have Made the S&P 500 More Concentrated Than Ever. Historically, That's Bad News for Stocks.

When examined over multidecade periods, Wall Street's three major stock indexes -- the Dow Jones Industrial Average (DJINDICES: ^DJI), S&P 500 (SNPINDEX: ^GSPC), and Nasdaq Composite (NASDAQINDEX: ^IXIC) -- are undeniable moneymakers. But when explored over shorter spans, the performance of these indexes becomes unpredictable.

Since this decade began, the major stock indexes have teetered between bull and bear markets on a number of occasions. While 2023 has been a relatively good year for the benchmark S&P 500 and growth stock-fueled Nasdaq Composite, a number of potential warning flags have emerged. Perhaps none is waving more frantically than the steadily increasing concentration of the S&P 500.

A person circling and drawing an arrow to the bottom of a very steep drop in a stock chart.

Image source: Getty Images.

The Magnificent Seven are responsible for nearly all the S&P 500's gains in 2023

The S&P 500 is widely viewed as the best benchmark of Wall Street's "health." It's a market cap-weighted index comprised of 500 generally profitable, time-tested companies, a few of which have multiple classes of shares. All told, the S&P 500 has 503 components, with representation from all sectors and most industries.

You'd think that a 500-company index would be fairly diverse and act as an accurate barometer for Wall Street, but this simply isn't the case, thanks to the rise of the Magnificent Seven.

In order of largest to smallest market cap, as of Oct. 13, the Magnificent Seven stocks are:

The Magnificent Seven bring two attributes to the table that make them irresistible to many investors. First, they're industry leaders with relatively sustained moats and/or competitive edges:

  • Apple accounts for a little over half of all U.S. smartphone market share and has the most robust capital-return program among publicly traded companies in the U.S.
  • Microsoft is enjoying a blend of the old with the new. Its legacy Windows operating system still dominates on desktops, while its cloud infrastructure service, Azure, ranks second inglobal marketshare.
  • Alphabet's Google has tallied at least 90% of worldwide monthly internet search share for over eight years. Alphabet also owns YouTube, the second-most-visited social site on the planet.
  • Amazon's e-commerce marketplace has more than five times the share of online retail sales as the next-closest competitor in the United States. Further, Amazon Web Services is the global No. 1 in cloud infrastructure services.
  • Nvidia is leading the charge for the artificial intelligence (AI) revolution. Around 90% of the graphics processing units (GPUs) used in AI-accelerated data centers derive from Nvidia.
  • Meta Platforms owns the prime social media "real estate," including Facebook, Instagram, WhatsApp, Facebook Messenger, and Threads. Meta attracted nearly 3.9 billion monthly active users in the June-ended quarter.
  • Tesla is North America's leading electric-vehicle (EV) manufacturer, as well as the only pure-play EV producer to achieve recurring profitability.

AAPL Chart

AAPL data by YCharts.

The other reason investors flock to the Magnificent Seven is their outperformance. While the S&P 500 is higher by nearly 13% on a year-to-date basis, as of this past weekend (ended Oct. 13), the equal-weighted S&P 500 is down by almost 1% for the year. In other words, the Magnificent Seven have been almost entirely responsible for pulling the benchmark S&P 500 higher this year.

Is the S&P 500 a house of cards waiting to topple?

In one respect, investors can be thankful for the sustained outperformance of the Magnificent Seven. Businesses with well-defined competitive advantages and long growth runways should be rewarded, as well as have greater influence over the S&P 500 if they're becoming larger over time.

However, history hasn't been kind to the S&P 500 when it's become overly reliant on an increasingly smaller percentage of its components. As pointed out this past week by Bank of America Global Research, the Magnificent Seven now comprise 29.6% of the market cap of the S&P 500. That's higher than the previous concentration peak of 29.1%, which preceded the S&P 500 losing more than a quarter of its value during the 2022 bear market.

According to a research report from Morgan Stanley, the 10 largest components of the S&P 500 have comprised around 20% of the index's weighting over the past 35 years. During the dot-com bubble, the concentration of the 10 largest components jumped to around 25%. As of this past weekend, the 10 largest components accounted for almost 32% of the S&P 500's weighting. It's an ominously high figure, given what's transpired the last couple of times the benchmark index became concentrated in an increasingly smaller number of companies.

Keep in mind that I'm not suggesting the S&P 500, and stocks in general, are in trouble solely because of poor market breadth. Rather, I'm pointing out that previous periods of high concentration for the S&P 500 left the stock market prone to significant downside if one or more of the index's more heavily weighted components failed to live up to lofty expectations.

While some Magnificent Seven components remain historically inexpensive relative to forecast cash flow, such as Meta, Alphabet, and even Amazon, other components appear priced for perfection.

For instance, while most auto stocks are valued at a single-digit price-to-earnings multiple, Tesla is trading at nearly 75 times forecast earnings this year. Tech stock Apple is also near the high end of its valuation multiple, despite its sales and profits modestly shrinking in fiscal 2023. Whereas a well-diversified stock index wouldn't be reliant on a single component for its success, the S&P 500 could topple like a house of cards if just a few heavily weighted components lose their luster.

A smiling person reading a financial newspaper while seated on their porch.

Image source: Getty Images.

When in doubt, pan out

However, investors' perspective can change drastically depending on their investment horizon. While a highly concentrated S&P 500 is less than ideal in the short run, it's not a particularly big concern if you're an investor with a long-term mindset.

For example, the S&P 500 has endured 39 instances since the beginning of 1950 where it's declined by a double-digit percentage. This includes the dot-com bubble and 2022 bear market, both of which featured instances of higher-than-normal concentration for the S&P 500 in a handful of its largest components.

But except for the 2022 bear market, every double-digit dive in the benchmark index since its inception has, eventually, been cleared away by a bull market rally. Although we're never going to be able to predict with 100% accuracy when downturns will occur, how long they'll last, or where the bottom will be, history pretty conclusively shows that the S&P 500, along with the Dow and Nasdaq Composite, increase in value over extended periods.

To add to the above, it generally pays to be optimistic. Four months ago, Bespoke Investment Group unveiled data showing that the average bear market in the S&P 500 since September 1929 has lasted 286 calendar days (about 9.5 months). By comparison, the 27 bull markets over the past 94 years have lasted an average of 1,011 calendar days. That's more than 3.5 times the length of the typical bear market since the Great Depression.

So no matter how stacked the deck may appear against Wall Street in the short term, meaningful declines in the major indexes always represent a buying opportunity for patient investors.

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John Mackey, former CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool's board of directors. Suzanne Frey, an executive at Alphabet, is a member of The Motley Fool's board of directors. Bank of America is an advertising partner of The Ascent, a Motley Fool company. Randi Zuckerberg, a former director of market development and spokeswoman for Facebook and sister to Meta Platforms CEO Mark Zuckerberg, is a member of The Motley Fool's board of directors. Sean Williams has positions in Alphabet, Amazon.com, Bank of America, and Meta Platforms. The Motley Fool has positions in and recommends Alphabet, Amazon.com, Apple, Bank of America, Meta Platforms, Microsoft, Nvidia, and Tesla. The Motley Fool has a disclosure policy.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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