1932 was the same! High concentration in the US stock market isn’t scary—the real danger is when it’s too expensive.

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On Wednesday, Robert Armstrong, a columnist for the Financial Times, published an in-depth article discussing the concentration of the US stock market. The article explores the current phenomenon of US markets being highly concentrated in the hands of a few technology giants and whether this concentration actually signals increased market risk.

Armstrong opens by describing a dramatic market day: after the AI company Anthropic launched a new legal job automation tool, software and professional services companies saw their share prices tumble over 3%. However, the tech giants were not spared either, while traditional sectors like energy, telecommunications, consumer goods, and materials became winners. This example suggests the market landscape is undergoing changes.

Armstrong's central view is: Market concentration itself is not frightening; what truly deserves caution is high valuation. Although the Mag7 tech stocks no longer dominate the market as they did a few months ago, the S&P 500 index remains highly concentrated. More importantly, historical data shows that such concentration is not abnormal; a similar situation occurred in 1932.

Market Concentration: Six Companies Make Up One Third

How concentrated is the US market right now? Armstrong provides detailed figures. Just six companies account for one third of the total market capitalization of the S&P 500 index, with Nvidia alone making up 7%. If you look at the top 62 largest companies, they collectively comprise two thirds of the index's total value.

From the perspective of net profit, the situation is slightly different but essentially similar. Those six giants contribute 27% of net profits, while the top 62 companies provide 63% of net profits. Armstrong points out, This means that the largest companies often enjoy higher valuations—price-to-earnings ratios—than smaller ones.

This level of concentration raises a question that many analysts are asking: Does the high concentration of market capitalization make the market more dangerous? Should investors reduce exposure to the largest companies or sectors relative to their market weight?

History Tells Us: Concentration Is the Norm

Armstrong notes that the research paper by Per Bye, Jens Soerlie Kvaerner, and Bas Werker offers convincing historical evidence. They analyzed all companies traded on major US exchanges since 1926, including market capitalization and various profitability metrics.

The results are rather surprising. The authors write:

The relative importance of the Mag7 is not unique. For example, from the 1930s to the 1960s, seven companies occupied a similar share. "The peak appeared in May 1932, when AT&T, Standard Oil, New York United Gas, General Motors, DuPont, Reynolds Tobacco, and United Gas Improvement accounted for roughly one third of total market capitalization."

This shows that market concentration is not unique to the present age, nor is it a special product of the technology era. The same concentration pattern existed in the industrial era. In other words, the dominance of a few large companies seems to be a common feature of capital markets.

The research also revealed an important finding: company fundamentals (such as revenue and profit) do track changes in market capitalization concentration, but the correlation is loose and shows cyclical fluctuations.

The paper also points out that when market capitalization concentration reaches an extreme (i.e., when the number of companies accounting for one third of total market value drops to a historical low, currently below 0.5%), the share of revenues, profits, and cash flows held by these largest companies actually falls to historical lows, about one fifth.

So, does high concentration also mean long-term returns will be low? The paper notes:

On its own, market concentration does have a negative predictive effect on returns (high concentration, low subsequent returns), but this is not the case if valuation factors are controlled for... Holding valuation constant, higher concentration is actually associated with higher future returns!

Mathematical Models Confirm: Concentration Is a Natural Result

The second part of the paper uses mathematical models to further reinforce the argument that market concentration is a normal phenomenon. The study employs a "standard geometric Brownian motion diffusion process" model, incorporating "common market factors and company-specific shocks."

Specifically, in this model, returns follow a random process. You can think of a company's market value as being constantly affected by various shocks—productivity and innovation shocks, good or bad leadership, luck, and misfortune. Over time, most companies remain small (their gains and losses offset each other), while a few receive many positive shocks and grow into giants.

In an analogy, the stock market is like an ongoing dice game. Most players' outcomes tend toward the average, but there are always a few who are exceptionally lucky and keep rolling high numbers. This is not surprising, but rather a natural result of probability. The same logic applies to market concentration; it is the outcome of market mechanisms operating naturally.

Risk warnings and disclaimerThe market carries risks and investment should be cautious. This article does not constitute personal investment advice, nor does it consider the particular investment goals, financial situation, or needs of any individual user. Users should consider whether any opinions, views, or conclusions in this article suit their particular situation. If you invest based on this, you do so at your own risk. ```