Exploring tech-powered equity markets

The widespread adoption of paradigm-shifting technological advancements has been a driving theme of stock market rallies since at least the advent of steam-powered rail transportation. There have been many instances when the promise of new technologies measured up to the market hype, and others when the frenzy far outstripped economic reality. Still more saw their genuine promise eclipsed by newer disruptive technologies.

Investors may be seeking to determine which group best characterizes today’s tech-powered equity market advance. Excitement over generative artificial intelligence (AI) has been the prevailing market-moving theme for over a year, and some of the stocks that have been its chief beneficiaries have seen multi-fold price increases in that period.

Nothing has done more to propel AI into popular awareness than the launch of ChatGPT in late 2022. This app put the generative capabilities of AI into the palms of millions, comparable to an “iPhone moment” or the advent of the internet browser.

We know the iPhone has demonstrated remarkable staying power despite the commoditization of the smartphone market. At the other end of the spectrum, browsers gave a platform to the dotcom bubble, in which an entire class of stocks rose dramatically, and fell even harder, as the speculative hope for emerging web-native business models evaporated.

The dotcom era and today: similarities and differences

There are obvious parallels between today’s AI-driven market and past tech-centric advances. The dotcom era serves as an apt comparison given its relative proximity, and we see important similarities and differences between the two periods.

Index concentration: One of the defining features of both the dotcom era and today’s market profile is the high degree of concentration among the largest stocks in the S&P 500 Index. The larger the company, the heavier its index weight, and mega-cap tech-oriented stocks dominate the S&P 500 today.

The top ten stocks now account for almost 34% of the index weight, surpassing the dotcom bubble peak of about 27% and representing the most top-heavy market in 50 years. In fact, the weight of today’s so-called Magnificent 7 stocks (28%) is higher than the dotcom era’s top ten.¹

Performance: This small group of the largest stocks has outsized sway over market performance, with the top ten contributing 63% of the S&P 500’s returns in 2023.²

The less-concentrated market of the dotcom era produced considerably less-concentrated returns, with the ten largest stocks topping out with a contribution of 49.5% of S&P 500 performance in 2000 in the form of losses.³

Exhibit 1: The equity market has been putting most of its performance eggs in one basket

Sources: FactSet, Fiduciary Trust International

 

Earnings: High concentration and such stark divergence in recent returns raises the question of whether these top-performing stocks deserve all the attention. Three of the four sectors with the highest year-over-year earnings growth in fourth-quarter 2023 were communication services (44.7% growth), consumer discretionary (34%) and information technology (22.7%), all of which are led by major household technology companies.⁴

Forecasts suggest that near-term earnings growth could reinforce top-heavy market conditions. The top four stocks by estimated contributions to S&P 500 earnings growth in first-quarter 2024 are expected to deliver 80% growth while the other 496 stocks are projected to be essentially flat.⁵

Here’s where a contrast to the dotcom era gets interesting. Equity markets welcomed a rich pipeline of IPOs during the late 1990s. Many of these stocks sported business models that prioritized web-traffic growth over cash flow and earnings. As paths to profitability failed to materialize, these companies folded or were acquired at a fraction of the prices they commanded at peak optimism.

Today’s IPO pipeline is much more subdued and the path to profitability tends to be worked out prior to going public. We had a brief return to dotcom-era IPO levels in 2020 and 2021 largely fueled by “blank check” special purpose acquisition companies (SPACs). This wave also washed out as capital costs increased throughout 2022 and 2023.

Exhibit 2: SPACs drove a temporary return to dot-com era IPO frenzy

Source: Goldman Sachs

 

Valuations: U.S. equity market valuations are not a bargain today from a historical standpoint, with the S&P 500’s forward P/E ratio over 20x. But this broad figure masks a divergence—the top ten stocks trade at an average of 25x while the rest trade around 19x.⁶Furthermore, both the top ten and the broad market are less expensive today—even as the S&P 500 has been making all-time highs—than they were through most of 2020 and 2021.

The contrast between the dotcom era and today’s conditions may be most evident in valuations. The uninterrupted stretch of sizeable gains from 1995 to 1999 while profitability was relegated to the back seat resulted in extraordinary valuations. The top ten peaked at a forward P/E of 42x while the full S&P 500 surpassed 24x.

No analysis of the dotcom era would be complete without observing that the NASDAQ Composite Index, which included many of the period’s conspicuously unprofitable IPOs, peaked at a P/E of 90x. That number is closer to 27x today, and remains below its level from two years ago.

A matter of concentration

The similarities and differences between the dotcom era and today are clear:

• Both periods were subject to concentrated market leadership, but today’s market is extremely top heavy.
• The largest stocks are having a much greater impact on market performance today.
• The market is dominated by large, stable, profitable tech companies. These stocks are more akin to the quality-growth blue-chip mold than the startup mindset we tend to identify with tech.
• Valuations are much more reasonable today, but still elevated among the largest stocks.

Taken together, we believe there’s a reasonable argument that the size, profitability and prospects of the top tech companies warrants their higher valuations. Their business models stand to benefit from AI’s transformative potential, whether that’s through consumer and business applications, hardware, or the need for the on-demand bandwidth that cloud computing can provide; many are well diversified across business lines themselves. The industry is also evolving along other lines, offering new platforms and products that stand to reshape the way we interact with technology.

Putting all this aside for a moment, our concern as portfolio managers would be no different if market performance was this heavily dependent on other sectors, industries or companies. It’s not where the market is concentrated that creates risk in this case, it’s the extent. Whether market concentration is a risk for markets will also depend on the path of overall economic growth and interest rates.

There have been instances over the last year during which market participation widened, only to narrow again. The make-up of U.S. equity market performance has been broader through this February and March, which is a positive development. A sustainable equity market advance requires this type of broader buy-in, and it would represent an optimal resolution to today’s extreme concentration. Another potential outcome could be a downgrading of the growth prospects for top tech stocks, triggering a re-rating of their valuations, which would cascade negatively through the equity market. Either way, investors need to anticipate the possibility that the AI rally will eventually run out of steam.

The risk of increased market volatility could arise from interest rates and inflation remaining higher for longer than anticipated. If they persist, we would expect these factors to eventually put pressure on today’s elevated equity valuations. Current market characteristics and the possibility of rising volatility reinforce the criticality of maintaining a diversified investment portfolio, which helps offset the market’s tendency toward concentration. Furthermore, investors should be able to distinguish between the "haves" and "have nots" within equities in terms of genuine profitability as the stock market’s bull run continues to mature.

The author would like to gratefully acknowledge the support of Baneesh Banwait, Senior Research Analyst, and Alex Sternberg, Senior Investment Associate, for their contributions to this article.