Explained: Can market concentration determine future returns? Take a look at S&P 500's past

The top 10 stocks account for a large percentage of the index, with the latest reading being very close to the all-time high of around 30 percent for the last two decades. This observation makes for a catchy headline, but we need to understand a few caveats: Are market returns concentrated or actually broad-based? Does market concentration have any relation with the index’s forward returns?

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We use the S&P 500 equal-weighted index as a proxy to see whether market returns are broad-based or not.

The graph below tells us that the market returns were much more skewed till the dot-com bubble era (as highlighted). However, in the last 20 years or so, we can see that the S&P equal-weighted index has either risen or fallen more than the market cap-weighted index, suggesting that the returns have been more broad-based, instead of a few stocks contributing to the return in S&P 500.

A similar comparison supports the argument that a few key stocks have not driven the bull market. Since the bottom of global financial crisis in 2009, the equal-weight index has outperformed the market cap-weighted index. We have also taken into account the performance from two market peaks to remove the starting period bias or the base effect.

There seems to be no evidence of market concentration.

Goldman Sachs closely monitors a measure called ‘breadth’, which assesses the degree to which a handful of stocks are driving market returns. We can see that the market breadth has been well above average over the last 12 months.

After seeing that index returns might not be as concentrated as one would guess, let us answer this: Can market concentration to estimate forward returns? Here’s a summary of data for the past 20 years:

The x axis shows the sum of the weight of the top 10 S&P 500 stocks at the end of every month for the past 20 years. The y axis shows the one-year forward index total returns starting the end of each month. We ran a linear regression and found the coefficient of determination to be zero.

The above means that market concentration has no explanatory power to describe forward returns. The correlation between market concentration and forward returns has been zero. It also busts a common misconception that the higher the concentration in the index, the higher the index return in the future, and vice versa.

We can put our minds to rest and conclude that index concentration has no significance to the return the index will deliver in the future.