One of the most significant phenomena in recent times is the mounting concentration risk associated with the so-called “Magnificent 7” stocks. The Magnificent 7 refers to the seven most influential stocks in the S&P 500 index. These stocks, including NVIDIA
NVDA
, Meta Platforms, Tesla
TSLA
, Amazon
AMZN
, Alphabet, Microsoft
MSFT
, and Apple
AAPL
, have dominated the market, driving significant gains in the major indexes.

However, the upward price momentum of some of these stocks is diminishing, indicating potential risks for investors. Fourth quarter earnings reports often set the tone for the market’s trajectory in the new year. NVIDIA’s stellar performance in this regard has fueled the market’s upward movement. However, beneath this veneer of success lies the alarming trend of market concentration.

Concentration Risk

Market concentration, particularly in the top market cap stocks, is a vital indicator of the level of risk investors face. As the index continues to soar, with fewer stocks driving its ascent, the associated risk of momentum reversing to the downside increases.

The Magnificent 7 gained 107% in 2023 compared to the S&P 500 returning 24%, most of those returns coming from the Magnificent 7. The meteoric rise in the valuations of the Magnificent 7 has brought concentration levels of the top ten stocks in the S&P 500 to 32%, a 50 year high according to a recent report from JPMorgan Chase & Co.

As fewer companies carry the burden of the index, the top-heavy index is a greater risk of suddenly toppling over. The recent dwindling of the Magnificent 7 from seven stocks positively contributing year-to-date to five may signal momentum in these alpha dogs may be starting to wain, leaving the major indexes susceptible to a momentum reversal.

Momentum Reversal

The Magnificent 7 have ridden the wave of momentum to new market highs. As strong as the Magnificent 7 business are, annual returns of 48% for Apple to 239% for NVIDIA in 2023, are not sustainable. Their momentum is ebbing, and when it shifts, the markets could experience a sudden jolt.

Momentum reversals can be particularly painful, especially given the heights that these stocks have reached. Tesla’s losses of 29% so far in 2024 exemplify what a momentum reversal can look like, serving as a stark reminder of the market’s inherent volatility.

Strategy Shift

Given the high concentration and the market’s reliance on a mere handful of stocks, a change in investment strategy might be in order. Trimming holdings in the Magnificent 7 could be a prudent move at this stage in the momentum cycle. Additionally, reducing exposure to cap-weighted indices like the S&P 500 and Nasdaq could safeguard portfolios against potential momentum reversals in the largest stocks.

Investors can consider diversifying their portfolios by including equal weight index exposure. This strategy has the potential to minimize downside risk in the event of a significant momentum reversal in the Magnificent 7 while still participating as markets continue to move up.

Over longer periods, equal-weighted indices may outperform their cap-weighted counterparts due to declining concentration, offering a diversified approach to managing market risks.

Changing Landscape

The present market environment presents both risks and opportunities that warrant careful consideration. Staying informed, exploring diversification strategies, and vigilance in portfolio management can help investors successfully navigate these challenges.

Amid market concentration and evolving dynamics, a proactive and strategic approach is critical for sustainable growth and risk mitigation. Momentum reversals are some of the quickest and most damaging of market dynamics. Staying ahead of the curve and making informed decisions ahead of potential reversals can be instrumental in achieving long-term success in the stock market.

The concentration risks associated with the Magnificent 7 stocks can pose significant challenges for investors. However, by adapting to the evolving market dynamics and embracing thoughtful risk management strategies, investors can position themselves to not only navigate these challenges but also capitalize on the opportunities that lie ahead.

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