Let's Put To Bed The Argument S&P 500 Will See A Drawdown After Being Lifted Up By Only 5 Stocks

The S&P 500 Index is often used as a barometer of the overall health and direction of the U.S. stock market. However, throughout its history, there have been instances where a small number of mega-cap stocks have exerted a significant influence on the index's performance. Let's explore the historical significance of such occurrences and their implications for investors. 

Most notably, we are referring to Apple AAPL, NVIDIA NVDA, Meta META, Alphabet GOOG, Microsoft MSFT 

The Power Of Mega Cap Stocks

Mega-cap stocks, typically characterized by companies with market capitalizations exceeding $200 billion, possess immense market power due to their size, influence, and widespread ownership. When a few of these mega-cap stocks experience substantial price movements, their impact on the S&P 500 index can be substantial. Since the index is market capitalization-weighted, larger companies have a greater influence on its performance.

Historical Examples

1. The Dot-Com Boom: During the late 1990s, the S&P 500 experienced a dramatic surge primarily driven by the astronomical rise of technology-related mega-cap stocks. Companies like Microsoft, Cisco Systems CSCO, and Intel INTC experienced exponential growth, propelling the entire index to new heights. This era is often referred to as the dot-com boom, characterized by soaring valuations and exuberant investor sentiment. However, when the bubble eventually burst in 2000, the S&P 500 suffered a significant decline as the overinflated tech stocks led the market downturn.

2. The Rise of FAANG: In recent years, the dominance of mega-cap technology stocks, popularly known as the FAANG stocks (Facebook, Amazon, Apple, Netflix, and Google), has influenced the performance of the S&P 500. These companies have enjoyed remarkable growth, driven by technological innovation, changing consumer behaviors, and expanding market share. The ascent of FAANG stocks has resulted in substantial gains for the S&P 500 index, leading to concerns about the concentration of power within a few companies.

Implications For Investors

The influence of a small number of mega-cap stocks on the S&P 500 can have both positive and negative implications for investors. On the one hand, when these stocks perform well, they can contribute significantly to the overall index's positive returns, potentially benefiting a broad range of market participants. On the other hand, an excessive reliance on a handful of stocks creates a vulnerability known as concentration risk. If these stocks were to experience a significant decline, the index and portfolios that track it could suffer adverse consequences.

Given the potential risks associated with an overreliance on a few mega-cap stocks, diversification remains a crucial strategy for investors. By spreading investments across various sectors and market capitalizations, investors can mitigate the impact of any single stock's performance on their portfolios. Additionally, careful analysis and research into individual stocks can help identify opportunities and potential risks, enabling investors to make more informed decisions.

Throughout history, the S&P 500 index has experienced periods where a select few mega-cap stocks have exerted significant influence over its performance. Recent data presented by BMO suggests that even with the market being upheld by a handful of stocks, it doesn't mean breadth is deteroriating, but catching up. Also, the index recorded a 13.2% annualized price return during these periods of narrowing market breadth with the only loss coming in 2001-2003. 

Source: BMO Investing Strategy Group

Warning:

While a handful of stocks lifting up the entire stock market can contribute to positive market performance and investor returns, it also carries potential risks such as vulnerability, lack of diversification, and market distortions. A healthy stock market typically exhibits a balance between the performance of individual stocks and the broader market, with a diverse range of companies contributing to overall growth. Therefore, it is generally beneficial to have a more balanced and diversified market, which can help mitigate risks and enhance long-term stability.