Should investors worry about market concentration?

A small number of stocks are driving most of the outsized gains in US equities this year. So is that a problem for investors? I'm Alison Nathan, and this is Goldman Sachs Exchanges. Each month, I speak with investors, policy makers, and academics about the most pressing market moving issues for our top of mind report from Goldman Sachs Research. This month, I spoke to 2 prominent market watchers who are an opposite size of this very relevant debate. David Costin, our chief US equity strategist in Goldman Sachs Research, believes that investors should be concerned about the high level of US equ

measure that's easy for people to comprehend, understand, track, follow, what have you, is the weight of the S and P 500 market cap that is contributed by the top 10 stocks. We have data going back 45 years, and we have data on a daily basis. You can actually look at it very specifically. And the specific number is those top 10 companies today comprise around 36% of the market cap. And if you go back over time, it's around 20%. At the peak of the dotcom boom in 2000, it was about 25%. And then we used another approach or time series that brought the data back a 100 years. Today, 36% of the mar

So how concerned should investors be about this high level of concentration today?

So a critical observation is that a high concentration market has information about long term forward returns, not necessarily near term returns. So the way you posited the question was, how concerned should they be about it today? They should be concerned about it from a long term investment perspective. We'll take 10 years as a long term measure. So it doesn't tell you what's the risk out of the market in the next week or month or 6 months, maybe a year. It is informative about the long term return prospects. And one of the reasons is that valuation and concentration are 2 distinct variables

in your analysis, market concentration is a consistently reliable indicator of future returns?

Well, in our model, it's statistically significant in terms of incremental adding value and explaining forward returns. What I mean by that is if you think about how to forecast longer term returns, the model looks at a variety of inputs, valuation being the most important informative variable about what the returns are likely to be going forward. The profitability of companies is another variable. Interest rate environment today would be important information content about total returns. And concentration similarly adds to the accuracy of our forecast. So we can both model including concentra

If you think about what's driving that unique market concentration factor that's weighing on that 10 year average, What's the intuition behind why that drags on returns? The

intuition is with high concentration, the forward realized volatility is likely to be greater because it's a narrow group of companies driving the index. Any portfolio, if you have a relatively few number of constituents, the return is going to be more volatile than in a broadly diversified portfolio. And investors are not being compensated because the valuation is not attractively valued for this expected higher realized volatility. And the reason that we make that statement is the following. If you look at these leading stocks, they trade today with a negative risk premium. We have not seen

So how might you be wrong? In other words, if it turns out 10 years from now that this argument was incorrect, that high concentration did not in fact drag out S and P 500 returns, where might you have gone wrong? Obviously,