The top performing tech stocks that may be the biggest risk in markets today

There’s something unusual, and even a bit frightening about the top 5 companies in the S&P500. You can probably guess which companies are the top 5 and it’s a tech heavy list: Apple (NASDAQ: AAPL), Microsoft (NYSE: MSFT), Amazon (NASDAQ: AMZN), NVIDIA (NYSE: NVDA) and Alphabet (NASDAQ: GOOGL).

But what’s concerning about this list has nothing to do with any AI terminator fears and everything to do with the concentration risk they pose to global equity markets. 

These stocks have been responsible for the bulk of returns offered this year by the S&P500, they are valued at extremes and their market capitalisation is also a significant portion of the S&P500. And that’s before we consider the sector concentration.

Brendan Paul, portfolio manager and co-head multi asset for Atrium Investment Management, views the concentration risk from these stocks as being one of the largest risks to avoid in equity markets today. He’d call it an opportunity in itself to avoid them, given much of the market has glossed over this concern.

“The market cap of the top five stocks, for example, are around 25% of the S&P500. Now, that exceeds the concentration that existed in the 1999-2000 markets where there was a big concentration in those tech stocks as well,” he says.

If those years ring any alarm bells, they should. It was the timing of the dot.com bubble.

In this edition of Expert Insights, Paul discusses how managing this concentration risk is an opportunity for investors, why Atrium anticipates an acceleration in the market slowdown and how he has tilted his portfolio for the coming market.

Edited transcript:

What is the market outlook for the next year?

It’s a really interesting time in markets. We feel there's a bit of a conundrum at the moment, especially when you look out around that 12-month timeframe.

Equity markets are clearly holding a glass half full outlook at the moment. For example, they are pricing in earnings growth in the US of around 10 to 12% for the next 12 months. On the other hand. bond markets seem to be a lot more pessimistic, probably a glass half empty type of outlook. For example, pricing in a hundred basis points of rate cuts in the US next year suggesting a slowing economy will afford the central bank the ability to cut rates.

That's really a dichotomy you don't normally have. We have earnings growth because of a robust growing economy, you wouldn't see rate cuts as if the economy is slowing. So we're really at odds at the moment.

I think participants are scratching their heads a little bit about the resilience of economic growth. Where is this recession we were supposed to have? I think to explain that, you probably have to go back a step to the pandemic and the huge amount of stimulus that was put into the system. It built up really, really large savings buffers for households and businesses as well. Those savings buffers are slowly being eroded and we see that expiring in the next six to 12 months.

We think that we're really on the cusp of an acceleration in the slowdown. You're starting to see some small cracks come through in the consumption data in the most recent earning season, both here in Australia and in the US. And you are also seeing some cracks in the employment market as well where unemployment's just starting to tick up off its lows.

We’ve got a bit of a cautionary tone on that outlook, and we're probably siding a little bit more with the bond market than the equity outlook at the moment.

What are some of the key opportunities and risks that investors need to be wary of?

We see an opportunity in avoiding a specific risk, if I might put it that way. The risk we see at the moment is really around the concentration in equity markets.

Equity markets this year have had really good returns, especially in the US and this is concentrated in the tech sector. In fact, if you look at it, the top seven or eight stocks really speak for the entire returns of the market. What that has led to is a very concentrated market.

The market cap of the top five stocks, for example, are around 25% of the S&P500. Now, that exceeds the concentration that existed in the 1999-2000 markets where there was a big concentration in those tech stocks as well.

But if you look under the hood, it's also valuation extremes as well.

On a Enterprise Value/sales metric, we're up at around 10 times next year's sales for those top five stocks. That's getting up to levels we just haven't seen since the tech bubble in 1999-2000. 

The risk is that investors that, for example, might be in an S&P500 market-weighted ETF are really taking quite a concentrated bet in that tech sector. Should that unwind for whatever reason, and some of those extreme valuations come back to the market, then we think that poses quite a risk. For example, we know that after that bubble burst in 1999- 2000, an equal weighted index, where you weight all your stocks equally rather than by market cap, outperformed the market cap index by about a hundred percent over the next seven years.

We want people to be aware of a risk that they're taking that they don't really appreciate.

Have you adjusted your asset allocation for this outlook?

Over the last 12 months, we’ve had our equity weights in the lower end of our range. We're concerned about the excessive optimism that's been priced into markets. Really the returns that have come from the market year-to-date have come from multiple expansions. So not through earnings growth, but rather through a higher price-to-earnings multiple. 

We’re really cognisant of that so we’ve down-weighted our equities to the lower end of our equity range. We’re carrying a reasonable amount of cash. We like the optionality that cash provides.

We think that this long-awaited recession will provide some really interesting opportunities to deploy capital into. The other bucket we’re really maximising is what we call our diversifiers bucket.

At Atrium, we focus on a risk-targeted approach. A big part of that is allocating to diversifiers or liquid alternative strategies because we think a strategy that can deliver absolute returns regardless of the direction of the equity market of the bond market, for example, could be especially valuable in the coming 12-18 months.

Have you incorporated any tactical tilts for short- and medium-term risks and opportunities?

A tactical tilt would be the higher-than-average cash waiting to take advantage of short-term dislocations in the market, should they come along.

The other thing we’re done is started to add some duration or some government bond exposure to our multi-asset portfolios. For a long time in the prior decade, we had no government bond exposure. 

We didn’t like the risk-reward when the yields on ten-year government bonds were down around 1.5%. With government bonds in Australia and the US having a 4-5% yields, we’ve started to like that as part of our multi-asset portfolios. So we are tilting a bit towards duration.

The last one we have at the moment is a position that stands to benefit should the Chinese currency continue to devalue. A big risk that people are focused on is the risk of the Chinese economy struggling with its property sector and other parts of the economy. We have some protection that will benefit should there be further devaluation in the Chinese currency.

Learn more

Brendan and the team at Atrium help investors maximise the benefits of diversification by bringing together a blend of best-in-class investment managers and strategies, carefully selected, and incorporated into a range of professionally managed multi-asset diversified solutions. Visit their website to learn more

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