The S&P 500 Looks Strong—Until You Count How Few Stocks Are Doing the Lifting

At first look, the numbers appear comforting. Last week, the S&P 500 closed at 5,911.69, up 1.9%. It is currently 65% higher than its low from October 2022. Screens glow green once more on lower Manhattan trading floors, and the customary buzz of assurance has returned. It appears that investors think the storm is over. But take a step back. Count the stocks that are actually lifting. The perspective shifts.

The rally seems larger than it actually is. As you pass the upscale asset managers’ lobbies in Midtown, you’ll hear portfolio managers discussing “participation” and “exposure.” However, a close examination of the index’s constituent parts reveals that a disproportionate portion of the gains have come from a small group of mega-cap names, many of which are associated with enthusiasm for artificial intelligence. The remainder of the market appears more hesitant, fluctuating sideways, stalling, and rising in fits.

This concentration might just be the result of the market rewarding true innovation. After all, significant advancements preceded the 2000 internet bubble. However, history also suggests something less cozy: fragility rises as leadership becomes more limited. It appears to be a smooth surface. Not so much for the foundation.

A sobering reminder comes from recent research by Michael Mauboussin and Dan Callahan of Morgan Stanley, who examined 6,500 stocks over 40 years. The median drawdown for the top 20 stocks from 1985 to 2024 was 72%. From peak to trough, it took almost three years. more than four years to recuperate. Imagine explaining that patience is a virtue while watching quarterly statements shrink and holding a position that drops by almost three-quarters. The mere thought of that makes my stomach knot.

According to renowned investor Peter Lynch, the stomach, not the brain, is the most crucial organ in investing. That line felt dramatic, as I stood on the floor of the New York Stock Exchange years ago, watching traders yell through the turbulence. It feels literal today. Stronger stomachs are required in concentrated markets.

The S&P 500 itself seems diversified, which is the source of tension. Five hundred businesses. several sectors. worldwide sources of income. However, the biggest companies bear the brunt of the burden due to market-cap weighting. Even when half of its components lag, the index rises when a small number of them do, whether it’s due to speculative capital, chip demand, or optimism about AI. The index appears to be in good shape. less so than the median stock.

The results from Morgan Stanley highlight yet another unsettling reality. Of the stocks that experience maximum drawdowns, about 54% never fully recover. Just 90% of the previous peak is recovered by the median. While investors chase leaders, that statistic quietly lurks in the background. Whether today’s AI champions will resemble long-lasting franchises or just the newest trends before gravity steps in is still up in the air.

However, diversification has a silent power of its own. Historically, the S&P 500 has experienced a shallower maximum drawdown than the top individual winners. At its lowest point during the study period, the index dropped 58%, but it recovered faster than many of its key components. The extremes are lessened when the entire market is owned. It also entails acknowledging that while many stocks decline, a select few will yield disproportionate returns. In retrospect, it is easy to appreciate that asymmetry. more difficult in real time.

This moment seems to be more like 2000 than it is like 2007 or 2021. Diversification provided a haven even though valuations were stretched at the time. Deep value stocks and non-US stocks now trade at much less demanding multiples. Without completely giving up on stocks, investors could move away from companies with a lot of AI. Despite being uneven, the opportunity set isn’t empty.

Valuation levels are still close to historical highs. The S&P 500 trades near dot-com-era peaks on some metrics. AI startups are receiving funding from venture capitalists at startling valuations, sometimes even before their business plans are fully developed. It feels more like momentum chasing than sober analysis to watch money pour into quantum computing companies that are trading at triple-digit price-to-sales multiples.

Earnings growth might make it worthwhile. For example, Nvidia’s revenue explosion is real. However, over time, returns can be compressed by capital intensity, scale, and competition. It appears that investors believe today’s leaders will always have the ability to set their own prices. That assumption has previously been punished by markets.

Another practical issue is brought up by this rally’s narrow scope. The index may rapidly sag if a small group of stocks falters due to regulation, earnings misses, or just changing sentiment. Breadth is important. It serves as a shock absorber. Volatility increases in its absence.

There is a silent discussion taking place as this is being watched from London trading desks, where global portfolios balance European value and emerging markets against U.S. exposure. AI names are being trimmed by some managers in order to reallocate funds to less expensive assets. Others worry that if the surge continues, they will miss out. The fear of performing poorly is still just as strong as the fear of failing. That might be the true tale. The question is whether the S&P 500 is robust, not if it is strong.

It’s common to compare markets to tides. All boats rise with the tide. But occasionally, smaller boats stay stranded in shallow water while only yachts rise. From a distance, it appears to be advancement. The imbalance is more noticeable up close.

At 5,911.69, the S&P 500 appears to be strong. 65% higher than the low of 2022. almost back to its peak in February. However, the question remains, looming over trading floors and portfolio evaluations: what proportion of stocks are actually bearing the burden?

As of right now, the answer seems to be less than what comfort would indicate. Only time and a few quarterly earnings reports will tell whether that concentration turns out to be visionary or risky.