By
Linda Bakhshian
October 29, 2024
Third quarter 2024 recap
Equity markets in the US and around the world rose once again during the third quarter, continuing their recent
pattern. However, unlike recent history, most gains did not come from the largest names in the index. The total
return of the S&P 500® Equal Weight Index this quarter was comfortably ahead of the cap-weighted S&P 500 Index. In
addition, the Russell 1000® Growth Index was one of the weakest performers.
Many equity markets dipped briefly at the start of August, as investors began to worry about increasing economic and
geopolitical tension in the Middle East and political risks in the US. This proved short-lived, and by the end of the
quarter, many indices had reached new highs. The US Federal Reserve’s (Fed) decision to cut interest rates by 0.5% at
its meeting in late September, and its comments about maintaining its dual mandate on inflation and unemployment,
were broadly reassuring to equity investors.
We continue to believe that broad economic trends and corporate earnings appear resilient and should support future
market returns. The third-quarter earnings season is expected to show profitability growth beyond the largest growth
companies, and for most sectors, on a year-over-year (YoY) basis. Supporting this outlook is a relatively healthy
level of economic activity and consumer spending, which remains on solid footing, despite pressures from higher
interest rates and the cumulative effect of inflation. Investors, however, will continue to be focused on the
Magnificent Seven, as earnings are expected to decelerate to the high teens range YoY, down from a peak of 60% YoY in
the fourth quarter of 2023.
The strongest-performing sector in the S&P 500 Index was utilities at 19%, while the weakest was energy at -3%. In a
reversal of recent trends, large-caps lagged small-caps in the US. Outside the US, there was a wide range of returns.
In US dollar terms, the strongest performer among the major developed markets was the Hang Seng Index in Hong Kong,
which generated a total return of 22%, while the weakest was the EuroStoxx 50 Index with 7%.
Navigating investments through the age of dominance
Throughout history, equity markets have undergone cycles of significant concentration, in which a few dominant
companies have disproportionately influenced total market capitalisation. Notable examples include the ‘Nifty Fifty’
era of the 1960s and 1970s, and the late 1990s tech bubble. In recent years, this trend has reemerged with the rise
of the FAANGs (Facebook, Apple, Amazon, Netflix, Google) and the Magnificent Seven (Meta Platforms, Apple, Amazon,
Google, Microsoft, Tesla, NVIDIA). During periods of high market concentration, investors can achieve significant
short-term gains by focusing on index investing. However, such a strategy can carry risks for passive investors as
the concentration unwinds, a transition that can sometimes happen very quickly.
Since the end of 2005, the 10 largest companies in the Russell 3000® Index have outperformed the broader index,
especially since early 2020. However, when we look at the Russell 3000 Index over a longer period, from 1995 to
September 2024, we find that the top 10 companies have delivered returns that are closely aligned with the broad
index. This suggests that while investing in dominant companies can yield strong gains when they are ascending, it
can also lead to significant underperformance if market conditions change quickly.
Figure 1:
Cumulative total return of 10 largest names within Russell 3000 since Dec 2005
Sources: FTSE Russell and FactSet (September 2024). Notes: Graph shows cumulative total return in
US dollars of 10 largest names, Russell 3000 Index excluding 10 largest names, and Russell 3000 Index; ‘10 largest
names’ is rebalanced monthly.
The cyclical nature of equity markets and the lessons of history should make us wary of relying too heavily on a few
stocks. Instead, we believe in building a diversified portfolio of quality companies to achieve more stable long‑term
returns and to mitigate the risks associated with market concentration cycles. We generally define quality as
companies with strong balance sheets, consistent free cash flows, and seasoned management teams that have exhibited
differentiated business models and can withstand market and economic cycles.
Learning from history
Both the Nifty Fifty and the tech bubble offer cautionary tales about the risks of concentration: even companies that
seem invincible can become overvalued and are susceptible to regulatory, market, and growth risks that simply may not
materialise at the same rates expected by their valuations. Some readers may remember the giants of days past, such
as Lucent, General Electric (GE), and Xerox in their heyday, and their painful falls. Currently, the top 10 stocks
account for more than 30% of the S&P 500 Index’s market capitalisation (treating Alphabet as a single issuer),
surpassing the 27% share at the peak of the tech bubble in 2000.
Top 10 stocks in each era
| 1973 |
2000 |
2024 |
| IBM |
Microsoft |
Apple |
| Eastman Kodak |
Cisco Systems |
Microsoft |
| Exxon |
General Electric |
NVIDIA |
| Sears |
Intel |
Amazon |
| General Electric |
ExxonMobil |
Meta Platforms |
| Xerox |
Walmart |
Tesla |
| Texaco |
Oracle |
Berkshire Hathaway |
| Minnesota Mining & Mfg |
IBM |
Eli Lilly |
| Procter & Gamble |
Citigroup |
Broadcom |
| Coca-Cola |
Lucent Tech |
Alphabet |
Sources: Goldman Sachs, companies’ market capitalization.
The large-cap technology firms that currently dominate the US equity indices have strong earnings and free cash flow,
helping justify their high multiples. But there are some risks that may not be immediately obvious. For example, the
current levels of capital expenditure by hyperscale companies resemble spending during the mainframe era of the late
1960s and overinvestment during the technology, media, and telecom (TMT) period of the late 1990s. Some pundits have
estimated that planned expenditure on artificial intelligence (AI) and its associated infrastructure may reach $US1
trillion over the next decade. Many firms are investing heavily in AI, hoping that it will allow them to maintain a
competitive edge and improve productivity, but it is not yet clear whether these investments will yield the expected
returns within the anticipated timelines. For example, adoption of Microsoft Copilot has been slower than initially
expected. Moreover, significant new investment in power generation and transmission will be required to run all the
global hyperscale and AI infrastructure activity that is currently planned.
To be clear, we are not calling for an end to all mega-tech investing, rather, a risk-adjusted and diversified
approach to quality investing that has a longer-term view. We believe that the broad theme of AI is structural and
that these technologies have the potential to enhance productivity in the future, just as the internet has continued
to grow. But we are also aware that this does not mean returns will materialise instantly or that the companies that
have been most successful over the recent past will continue to dominate equity market returns over the medium and
long term.
Looking ahead
The question facing investors is: what are the forces that could reduce market concentration from its current levels?
The question facing investors is: what are the forces that could reduce market concentration from its current levels?
Aside from an abrupt market correction, we can see two potential scenarios. The first is that index providers might
begin capping maximum weights in their equity indices, reducing the influence of the largest names and forcing sales
by passive indices. While this approach has been used for many years by thematic index providers, it is less common
in broad benchmarks. FTSE Russell, for example, consulted with clients and external committees before ultimately
deciding in August 2024 not to apply capping methodology to its broad indices. This highlights the real challenge for
passive investors: how to balance the dominance of a few large companies with the need for broader market
representation. Obviously, active managers have greater flexibility to address concentration risks by simply
adjusting their exposure to these dominant firms.
The second possibility is regulatory intervention. During both the Nifty Fifty period and the tech bubble, regulators
expressed concern about the dominance of a few companies and the systemic risks posed by their size. Today, similar
worries are emerging, leading to discussions about antitrust actions, increased regulation in the US and Europe, and
even the possibility of forced breakups. The Digital Markets Act of the EU is a prime example of regulation aimed to
curtail this threat.
Given the risks outlined above, active management, although currently unfashionable, presents a compelling
alternative. Over the longer term, stocks tend to follow fundamental earnings, as do markets. In addition to managing
concentration risk, active managers can capitalise on thematic investing and sector rotation. Our teams strive to
construct portfolios designed to yield positive, risk-adjusted, long-term returns by concentrating on the intrinsic
value of investments. We actively evaluate companies’ financial health, competitive strengths, and market positions,
pinpointing opportunities that are potentially less vulnerable to short-term market fluctuations and political
uncertainties.
Additional observations
As we get closer to the US elections in November, political rhetoric is becoming more heated, with both candidates in
full promotional mode. We have discussed in our previous quarterly update that, over the longer term, we believe
equity markets are more affected by policies than by party politics, and longer-term earnings are influenced mainly
by a company’s fundamental strengths and vulnerabilities. Our general advice to equity investors? Keep calm and carry
on.
Ultimately, we believe the most likely outcome is a divided government, though with a tail risk of a sweep by either
party. If our base case is correct, then policy changes will be more difficult to implement, a positive scenario for
the equity markets. A Trump sweep could result in higher tariffs, while a Harris sweep could lead to higher taxes,
neither of which would be favourable for inflation, the job market, equity markets, or the economy in general.
However, there are a few areas in which bipartisan agreement is likely to continue, such as continued semiconductor
restrictions on China, a pickup in reshoring and near-shoring activities, and higher spending on defence.
The potential for continued growth in the US was bolstered by the Fed reducing interest rates in September. This has
eased concerns about weakening labour market conditions and was largely possible due to more reassuring indicators of
core inflation. Any future easing will depend on data, and we believe that discussion is now shifting towards
understanding the end point of the easing process. Additionally, the People’s Bank of China (PBOC) recently announced
several measures aimed at boosting economic growth, which improves market sentiment, especially for Germany and
Europe more broadly. The US Treasury market yield curve has completely disinverted, generally a sign of an improving
economic outlook rather than an impending recession.
Historically, sectors that tend to outperform after the Fed begins cutting rates have been staples, real estate,
healthcare, and utilities. Quality factors also tend to perform better than cyclical factors. Broadly speaking, when
the Fed is cutting rates and there is rising uncertainty about the economic and political outlook, investors seem to
favour stable companies with predictable earnings and free cash flow. Even in a soft-landing scenario, we believe
quality factors are likely to outperform.
As we have discussed before, our fundamental equity teams invest in higher-quality companies across all asset
classes, styles, and geographies. They tend to deliver relatively more stable margins and earnings, and usually have
a differentiated and sustainable competitive advantage within their respective industry or sector.
Expert views from our network
Each quarter, we ask our investment analysts and portfolio managers for their views on issues they consider to be the
most topical. This quarter, we focused on opportunities in our US core and mid-cap strategies.
The case for mid-cap stocks
David Borberg | Client Portfolio Manager – US Mid-Cap
Investors should be mindful of recency bias when it comes to their US equity portfolios. While mid-cap stocks have
lagged large-cap counterparts in every five-year rolling period since early 2013, this performance metric doesn’t
tell the whole story. Historically, mid-caps have shone in more typical interest rate climates, showcasing a strong
track record of outperformance over both large- and small-caps since the inception of the Russell indices. The Fed’s
recent policies in response to the global financial crisis, the European debt crisis, and COVID-19 have
disproportionately benefited large-caps. Nevertheless, under more conventional interest rate conditions, mid-caps
demonstrate remarkable strength and resilience, making them a compelling diversification option for investors,
especially given the broader market dynamics and evolving interest rate landscape.
What makes mid-caps particularly intriguing is their capacity to dampen downside volatility similarly to large-caps,
while also capturing the growth potential typically associated with small-caps. In our view, this balanced
risk-reward profile truly sets mid-caps apart. In addition, mid-caps provide superior sector diversification
opportunities compared with large-caps, reducing the heavy weighting in index sectors like information technology and
providing potentially more opportunities for active portfolio management. With a history of robust revenue and
earnings per share growth, mid-caps offer a compelling investment case. They strike a fine balance between stability
and growth, catering to investors looking for both security and the potential for higher returns across various
economic conditions. Despite comprising more than 20% of the tradable US equity market, we believe mid-caps are
underappreciated, representing just over 9% of invested US equities, which signals an untapped opportunity for
discerning investors.
Opportunities in large-cap core stocks
Erik Becker | Head of US Large Cap Core Equity
Core managers have a distinct advantage – an ability to just buy good fundamentals, regardless of investment style.
This belief is grounded in the idea that a core manager is well-placed to capitalise on opportunities across the
equity market, not just within the high-growth sectors. The value lies in seizing market opportunities and
identifying companies capable of moving across the valuation spectrum – from value to growth – as their business
fundamentals evolve. This shift can lead to a significant reevaluation of how these companies are perceived and
valued in the market. The aim is to uncover a select group of companies with strong potential before they become
widely recognised, such as finding undervalued gems in various sectors at pivotal moments.
The period from 2020 to 2024, marked by the COVID-19 and post-COVID-19 landscape, has presented a fertile environment
for core managers willing to explore broadly for investment opportunities. Core managers can navigate through rolling
boom and bust cycles, identifying companies with temporary cyclical shifts due to extraordinary events, which have
proven to be profitable investments. This includes sectors like property and casualty (P&C) insurance, which
experienced unique challenges and opportunities stemming from changes in consumer behaviour, and consumer finance
stocks that became attractive during periods of economic stress. Currently, we are focused on finding value in
companies that, despite being in late-cycle environments, are undervalued relative to their long-term potential. This
includes investments in diverse sectors, from logistics to home improvement and auto lending, where companies face
temporary headwinds but have strong underlying fundamentals.
By embracing volatility and looking beyond traditional definitions of quality, the team has leveraged the broad
mandate of their asset class to deliver value to shareholders over many years.
Conclusion
Looking ahead, we maintain a cautiously optimistic outlook for US equities, supported by relatively healthy economic
activity, further possible interest rate cuts by the Fed, positive corporate profitability, and earnings growth.
Volatility is expected to increase in the short term, as investor focus is shifting to the potential impacts of the
US presidential elections, geopolitical tensions in the Middle East, and future inflationary trends. Despite
uncertainties, our investment teams remain focused on investing in high-quality companies and taking advantage of
dislocations that may emerge. We continue to find opportunities across profitable small- and mid-cap companies, the
value style, emerging markets, and real assets. While navigating investments through the age of mega-cap dominance
can be complex, we remain supportive of core and mid-cap strategies that give exposure to improving structural
trends, while maintaining growth, stability, and a risk-aware mindset to investing.
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