Will market concentration lead to a lost decade? Let’s look at the behavioral biases behind the question.
The S&P 500 has produced well above historical average returns two years in a row, mostly thanks to the continued surge in the largest technology stocks (aka the Magnificent Seven1) and artificial Intelligence (AI). Any time we see above-average moves like these, it’s standard practice to see pundits start to take the other side in their forecasts by warning of below-average or mean-reverting returns into the future. The current skeptic garnering the most attention is Goldman Sachs, who warns the S&P 500 is at risk of seeing downright mediocre returns over the next 10 years, resulting in a flat return (i.e., a “lost decade”) for stocks.
Why do they do that? Should we care? Most importantly, should we listen? The implications are real, because if you follow their advice and they get it right, you might temporarily preserve some capital. However, if you avoid their advice and they are wrong, there could be a substantial opportunity ahead.
Our Take: The Impact of the Mag Seven
Here’s what we’re talking about with clients on the topic of these forecasts.
The primary common reason across Goldman’s and others’ warnings is high valuations (about 22x forward earnings on the S&P 500, relative to the historic average of 17x). The S&P 500 is market cap weighted, which means that larger companies exert the most influence on the index’s returns and valuation statistics.
These seven stocks were approximately 34% of the S&P 500 (as of 12/31/2024) and were responsible for over 50% of the index ‘s 2024 return. This level of concentration is rare — there has been no other time in history when so few stocks have made up such a high percentage of the index. However, if you model valuations and returns returning to their historic averages, stock returns would be lower.
- Goldman says that investors should expect annualized returns of 3% per year, or 1% per year after inflation, for the next ten years.
- Vanguard projects annualized stock returns for the next decade between 3% and 5%.
- J.P. Morgan predicts 5% annual returns. If it is not immediately obvious, these are squarely pessimistic views, even if they have solid logic behind them.
What to Make of This: A Behavioral Approach
Like any good macro forecaster, it’s time to ask, “on the other hand…”
Economist Ed Yardeni disagrees with the aforementioned perspectives. His argument is that AI and other technological innovations will drive significant gains in productivity, which will support the S&P 500’s high forward price-to-earnings ratio. He has publicly stated that the S&P 500 will hit 10,000 by the end of this decade (the Index closed 2024 at 5,882), and he has been quite accurate in his bullish predictions over the past years.
Further, there are others who are bullish on U.S. equities over the next decade for similar reasons. You can think of this as a “companies will grow into these valuations” approach. Given the opportunity set, this also feels very plausible.
What should investors do with all this information? From a behavioral perspective, I am reminded of John Maynard Keynes’ famous quote: “Markets can remain irrational longer than you can remain solvent.”
This quote helps explain the inherent unpredictability of financial market returns. Since investors — who bet against rising markets will lose in the long term — can and should expect extended periods when valuations do not make sense. Valuation is historically a poor timing tool, as missing out on returns from overvalued periods has again and again proven costly.
There were times when I paid too much attention to the naysayers; thankfully, that was a long time ago. I had a lot of respect for GMO Founder Jeremy Grantham, and it was hard to ignore his advice when he turned very bearish a decade ago for similar reasons to Goldman today. Grantham warned investors in 2014 that stocks were too expensive and that investors should “get out now” before the strong returns of the prior few years were lost. But I did remain invested, and the 2014-2024 period ended up seeing some of the highest returns in history.
Our Advice: A Balanced Strategy
In the face of these below average warnings and forecasts, our advice is to stay invested in indexes that have technology but also seek parts of the market that are inexpensive relative to history. Valuation does matter in the long run, so we are always on the lookout for those opportunities that might be able to catch up. Profitable small and mid-capitalization stocks fit this category.
But, despite being opportunistic where valuations are low, we do not recommend avoiding technology stocks simply due to high valuations. We are likely on the cusp of one of the greatest leaps in innovation due to AI.
From a behavioral perspective, it is easy to want to sell and avoid risk. The mathematical arguments are aplenty. However, in the long run, these types of actions have proven repeatedly to be a poor decision.
Yes, there will be volatility, but sticking to an investment plan is the ultimate winning strategy — this has been true in the past and is very likely to be the case over the years and decades to come.
Contact us if you have questions on this topic or would like a review of your portfolio holdings. We are excited to see what the future brings!
[1] Apple (AAPL), Nvidia (NVDA), Microsoft (MSFT), Amazon (AMZN), Alphabet (GOOGL), Meta Platforms (META), and Tesla (TSLA)
