Markets have delivered strong year-to-date returns with the S&P 500 up over 10% through June while the Nasdaq is up 16%. AI, robust corporate earnings, and high retail investor participation have all collaborated to push the market to record highs. The consensus is that the second half of the year will extend the market streak to a fourth consecutive positive year. However, during periods of strength, it’s important to note that markets can become increasingly strong while simultaneously less stable.
One of the biggest mistakes investors make is assuming that strength and stability are interchangeable. Strength describes the quality of the underlying businesses, while stability describes the resilience of the overall system.
An economy can be supported by highly productive companies while remaining fragile because each company is dependent on the pricing of an underlying commodity. A sports team can have extraordinary talent while being reliant on a single superstar. A Formula One car can deliver exceptional driving performance, but it is not designed for all road conditions.
Consider a four-legged stool. You can build the stool from oak, or you can make it even stronger by manufacturing it from steel or titanium. But if you then move all four legs closer together, the stool becomes unstable. Nothing about the materials changed, just the leg geometry. Markets are similar.
Over the past 5 years, market commentators lamented the fact that the majority of market returns have come from a small number of companies, what is described as a “narrow market”. Over the past year, market leadership has shifted from The Magnificent 7 to AI and semiconductors. Most have concluded that market breadth has improved, but the reality is that concentration has merely shifted from one narrow sleeve of contributors to another.
Source: Bloomberg, S&P Global, Citadel Securities.
The names supporting the market are changing, but the legs of the stool continue to move closer together. As this happens, the assumptions required for returns to continue are also narrowing. Our economy has become reliant on fewer independent drivers than before:
- continued AI spending
- continued cloud demand
- continued semiconductor leadership
- continued earnings execution
- continued multiple expansion
The current market concentration showcases extraordinary businesses. Both the old and new market leaders are exceptional companies that possess durable competitive advantages and have exhibited an ability to effectively allocate and re-invest capital. But as more capital flows into the same companies, expectations rise, concentration increases, and valuations inflate. The market leaders have earned premium valuations but, in some instances, the market seems to be pricing in infinity.
The combination of instability and valuation inflation increases overall risk. The real risk isn’t concentration. The real risk is the possibility that reality differs materially from a narrowing band of expectations, or that the market now depends on assumptions that investors no longer understand.
At Richie Capital Group, our focus is always on investing in high-quality businesses. Given that our strategy has always embraced concentration, it would be disingenuous for us to criticize concentration in a broader index. However, our investment approach continuously evaluates not only business quality, market environment, and valuation, but also, perhaps most importantly, how each investment affects the correlations and overall construction of the portfolio. The businesses we invest in typically possess stronger balance sheets, higher returns on capital, and better management teams who can navigate unexpected market challenges and financial shocks. Investing with a concentrated portfolio requires, and showcases, skill.
As investors, we can’t control the strength of the markets, but we can construct portfolios stable enough to withstand the unexpected. Strength is the ability of a business to create value over time. Stability is the ability of a portfolio to withstand unforeseen change without experiencing disproportionate damage.
Concentration is not inherently risky. Poorly understood concentration is.
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