How to diversify as global stock markets grow more concentrated

Stock market concentration has increased dramatically in recent years at the market, sector, and stock level. However there are ways investors can diversify their portfolios while maintaining exposure to market leaders, according to Goldman Sachs Research.

“Market dominance is not unprecedented and is only a problem if it is not supported by fundamentals,” Peter Oppenheimer, chief global equity strategist and head of Macro Research in Europe for Goldman Sachs Research, writes in the team’s report. “That said, at the stock level in particular, dominant companies rarely stay the best performers over long periods of time.” (Listen to the Goldman Sachs Exchanges podcast on rising stock market concentration.)

Why is the US stock market so strong?

The US stock market has consistently been the world’s biggest over the past 50 years, but its share has been steadily climbing in the aftermath of the global financial crisis (GFC). It now captures around 45% of the global equity market, compared with about 30% in 2009.

The longer-term rise in the relative size of the US equity market has reflected the strength of the US economy, but its dominance has accelerated dramatically since the GFC, outstripping increases in market capitalization in Asia and Europe. Relative to GDP, the US share of equity market capitalization has risen steadily as well, though part of this reflects the fact that many non-US companies are now in the US stock market.

The stellar earnings growth of US companies over this time further explains their relative outperformance, Oppenheimer writes. Both share prices and earnings per share have consistently declined for non-US companies relative to their US-listed counterparts. In addition, the US stock market has more exposure to faster growing industries than the rest of the world, the reinvestment rate of companies in the US stock market is higher than in most other markets, and it enjoys greater liquidity that helps reduce the risk premium.

“The US economy is bigger and stronger than others and the growing trend towards US listings by foreign-based companies has added to this effect,” Oppenheimer writes.

While the US equity market has become increasingly expensive relative to the rest of the world, the premium being placed on US stocks is justified by superior rates of return, and the US valuation premium isn’t extreme when adjusting for its higher level of profitability and returns on equity, according to Goldman Sachs Research. Furthermore, diversifying outside the US isn’t always straightforward — other markets may be correlated with the US.

That said, “there are many quality growth companies” in other regions, and they should be considered as part of a diverse portfolio, Oppenheimer writes. The report cites Japan as a potentially attractive market among developed markets, and our analysts say there may be opportunities in India (notably growth stocks) and China (value stocks).

Goldman Sachs Research also recommends an overweight allocation to Europe’s consumer-cyclical stocks — companies whose performance is closely linked to the state of the economy and the business cycle — as the region’s activity rebounds (European consumers have high savings and real wage growth).

Tech sector domination could continue

Another source of increasing market concentration is among sectors, as technology, media, and telecom stocks have continued to capture a rising share of the global stock market, particularly in the US but also in other markets such as Asia.

While global technology profits have surged since the GFC, other sectors in aggregate have made “virtually no progress,” Oppenheimer notes. This dynamic was exacerbated by the pandemic, which enforced social distancing and drove demand for technology relative to other parts of the economy.

“While the rise in interest rates over the past couple of years dented the relative earnings growth of the technology sector, its superior growth rate has resumed over the past year,” Oppenheimer writes. Tech firms’ significant cash piles have given them a further advantage from the recent rise in interest rates, as they have reinvested their cash at a very high rate.

The level of tech concentration is not unprecedented among dominant sectors in the past, according to Goldman Sachs Research. The current tech sector is about the same size as the energy sector was at its height in the mid-1950s, for example, and it remains smaller than both transportation (which dominated in the 20th century) and finance and real estate (which drove the stock market in the 19th century).

“Over the past 200 years, the biggest industry represented in the stock market at each point in time has reflected the major driver of economic growth,” Oppenheimer writes.