U.S Megacap Stocks Are Carrying the Rest of the World. Here Are the Risks, and How to Diversify Them

The dominance of megacap tech stocks is not only shaping the U.S. stock market but also holding a significant influence on the global financial landscape. Currently, U.S. equities make up 70% of the MSCI World Index, which serves as a benchmark for large- and mid-cap companies across 23 developed markets. This concentration is the highest since the index's inception in 1986, reflecting the lowest exposure to non-U.S. stocks. Notably, the top five largest-cap U.S. stocks—Apple, Microsoft, Nvidia, Amazon, and Meta—contribute nearly a fifth of the index.

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Historically, the MSCI World Index's regional and country weights have shifted based on broader economic trends. While Japanese equities dominated during the 1980s, and European markets grew in the early 2000s, the current level of concentration in the U.S. market is unprecedented. This lack of diversification poses risks as it makes the global market highly dependent on company-specific factors.

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Goldman Sachs managing director Scott Rubner highlighted the significant impact of this concentration, noting that if one allocates $1 of their retirement account passively to the iShares ETF corresponding to the MSCI World index (URTH), 70 cents go into U.S. equities, with 18 cents allocated to the top five U.S. stocks.

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The lack of diversification raises concerns, especially as historical precedents suggest that such concentration often precedes steep market downturns. Instances in the late 1920s to early 1930s and in 2000 saw high levels of market concentration coinciding with market tops. BCA Research chief investment strategist Peter Berezin warns of the potential risks, stating that the market is currently on dangerous ground, and there is an elevated risk of something going wrong. He suggests that longer-term investors should view the current megacap tech rally as an indication that the party might end by the end of the year.

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The significant tilt towards U.S. stocks is driven by the rally in major tech companies, fueled by expectations that artificial intelligence will boost profits. Last year saw substantial gains for companies like Nvidia, Meta Platforms, Alphabet, Microsoft, and Apple. However, the concentration in these stocks is considered risky, and comparisons are drawn to historical events like the dotcom bubble in the late 1990s.

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Phillip Colmar, managing director and global strategist at MRB Partners, emphasizes the potential dangers of the premium commanded by these megacap tech stocks. He suggests that as long as momentum is with the 'Magnificent Seven,' referring to the seven-largest U.S. stocks by market cap, short-term portfolio performance will be closely tied to their performance. Colmar draws parallels to the dotcom bubble and the risk associated with not participating in such run-ups during periods of frothy market conditions.

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While high concentration is generally considered unhealthy for markets, Mike Dickson, head of research and product development at Horizon Investments, notes that there is more active risk in not owning these names than in owning them, given their significant presence in the overall market. Active managers may find it challenging to maintain massive overweights to these stocks, but the trend may persist.

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The lack of diversification is also influenced by the repatriation of funds from overseas markets back to the U.S., driven by a confidence crisis in China's stock market and geopolitical issues in Europe. Colmar suggests Japan as a potential bright spot in Asia, citing a tactical buy opportunity due to a cheap Yen, government-aided domestic momentum, and global trade cycle dynamics.

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However, opinions on European equities are mixed among portfolio managers. While earnings across European companies are outperforming, general pessimism towards the euro zone has led to stocks trading at a discount, presenting an opportunity. Berezin, on the other hand, remains pessimistic about the euro zone's prospects, recommending investors focus on sectors rather than regions. He points out that although European stocks are cheap, the limited tech presence in the region makes the existing tech stocks relatively expensive.

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In summary, the concentration of megacap tech stocks in the U.S. market is raising concerns among investors, drawing parallels to historical events that preceded market downturns. The lack of diversification and the significant influence of these stocks on global markets pose risks, and the ongoing rally may be viewed as a potential signal of an impending market correction by the end of the year. Investors are advised to carefully navigate the market landscape and consider diversification opportunities in other regions, such as Japan, while remaining cautious about the potential challenges associated with high market concentration.

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