Wall Street’s AI addiction: a fragile bet on mega-caps

Wall Street’s AI Addiction: A Fragile Bet on Mega-Caps Wall Street’s AI Addiction: A Fragile Bet on Mega-Caps

March 2025 Concentration in equity markets has reached unprecedented levels, especially in the United States. A limited number of mega-cap stocks, referred to as the "Magnificent 7", now dominate market indices, reflecting a convergence of technological innovation, speculative enthusiasm, and the hopes triggered by generative AI. However, this situation exposes the markets to unexpected bad news from the“Magnificent 7”, highlighting the need for diversification.

Top stocks’concentration: An unprecedented level

When analyzing U. S. market cap-weighted indices, it is striking to see the dominant weight of certain companies linked to artificial intelligence and technology in general. The five largest U. S. companies currently represent about 30% of the Bloomberg USA Index, equivalent to the 500 smallest companies in the index. Source: TOBAM, BBG, as of Dec 2024. The Benchmark reflects the BBG US Mkt L/M NR index from 26/03/2007 and the MSCI USA prior to that. Why is this figure particularly interesting today? First, this level of concentration is unprecedented, even exceeding that of the dot-com bubble in the 2000s. Second, one might think that these large companies are not very similar. However, historically, the largest capitalizations in the U. S. index are highly correlated with each other—much more so than the rest of the market! The risk for a "passive" investor is then to limit the number of risk premiums they are exposed to, making them more vulnerable in the event of a systemic shock.

Disconnect Between Valuations and Profits Another symptom of market concentration in the U. S. is the disconnect between stock valuations and corporate earnings: the 10 largest companies in the S&P 500 account for nearly 40% of the index as of the end of 2024, while their share of the index’s earnings does not exceed 25%. This disconnect began in 2015 and has continuously worsened. Likewise, the valuation ratios (P/E ratio) of the ten largest companies in the index are, on average, 15% higher than the rest of the market. S&P 500 – Historical valuations of the ten largest stocks (12/31/2004 – 12/31/2024)S&P 500 – Historical valuations of the ten largest stocks (12/31/2004 – 12/31/2024)

S&P 500 – Historical valuations of the ten largest stocks (12/31/2004 – 12/31/2024)

This concentration poses a problem during crises, as market cap-weighted indices tend to maximize their exposure to the most concentrated sectors just before crises occur:oil in1972, IT in 2000, banking in 2007, etc.

This level of concentration indicates that the market has already factored in very high growth expectations for the mega caps in the future, making them susceptible to any unexpected negative news. This was evident on January 27th when the Chinese company Deep Seek announced advancements in artificial intelligence, claiming to have trained a generative AI chatbot at a lower cost and time compared to market leaders. As a result, Nvidia's stock dropped by 17% by the end of the U. S. markets, as it was assumed that increased computing efficiency would decrease the demand for AI chips/equipment. Determining if Deep Seek is a real threat to Nvidia business model is, at the time of writing, pure speculation. However, what’s for sure is how fragile the US mega cap valuations are to any unexpected event. AI technology is undoubtedly a technical revolution, which is still in its infancy. As the next big thing, AI attractsresources and capital, but at a high riskwhich is not factored in current market pricing.

The importance of a diversified approach Investors looking to create more resilient portfolios should consider adiversified approach. Our patented TOBAM Maximum Diversification® strategy builds portfolios that maximize the diversification ratio (a measure developed by TOBAM to evaluate a portfolio's exposure to market risk premiums). In brief, this portfolio is the most diversified one can buildfor a given liquid universetaking into account weights, risk of individual stocks and how correlated these stocks are. We believe the Anti-Benchmark and Max Div strategies are one of the best fits for investors wary of how US tech concentration is jeopardizingtheir portfolio return over the medium term. They are both reducing risk overall, and most importantly are lowly correlated to the specific fate of US tech.

January 27th provides for an illustration of this feature: despite the tech-heavy Nasdaq Composite closing 3.1% lower and S&P 500 falling by 1.5%led by NVDA (-17%), our US Maximum Diversification strategy remained unaffected by the news and generated a 0.1% return.

Prioritizing diversification through correlations analysis and proper risk-weights management is key to deliverareal protection during periods of deconcentration. As the analysis below demonstrates, Max Div US is the only large cap portfolio alternative that performed positively during prolonged period of deconcentration over the past 24 years, offering convexity relative to the concentration risk. Source: TOBAM and Bloomberg. Performance returns are stated in USD and are gross of fees. The period presented above shows the gross performance of the strategies from 05/06/2000 to 31/12/2024. Beyond specific events like Nvidia in Jan 25, our Max Div approach is, by design, aiming to improve the long term risk/return profile of portfolio across the whole concentration cycle. A systematic approach to diversification may be the best way to capture the full risk premium of the market over the long term.

ABOUT TOBAMTOBAM is an asset management company offering innovative capabilities designed to maximize the benefits of scientific research to build efficient investment exposures. TOBAM’s expertise relies on 3 core pillars:TOBAM’s Maximum Diversification® approach, supported by original, patented research and a mathematical definition of diversification, provides clients with diversified core exposure, in equity and fixed income markets. A research driven, Solutions division (TOBAMSolutions®), dedicated to build customized solutions and services to sophisticated institutional investors, A LBRTY® strategy range, which aims to help investors substantially mitigate their exposure to autocratic regimes in their portfolio. In line with its mission statement and commitment to diversification, TOBAM also launched a satellite activity (CRYPTOBAM®) on cryptocurrencies in 2017. TOBAM Maximum Diversification®, TOBAMSolutions®, TOBAM LBRTY® and CRYPTOBAM® illustrate TOBAM’s systematic “out of box” dedication to demanding investors. TOBAM manages USD 2 billion (as of 31December 2024). Its team includes 31 finance professionals based in Paris, New York and Dublin. For more information, please visit www.tobam.fr or tobamdirect.com CONTACTSParis 24-26, Avenue des Champs-Elys ées75008 Paris France Dublin New York Client Serviceclientservice@tobam.fr ABOUT TOBAMTOBAM is an asset management company offering innovative capabilities designed to maximize the benefits of scientific research to build efficient investment exposures. TOBAM’s expertise relies on 3 core pillars:TOBAM’s Maximum Diversification® approach, supported by original, patented research and a mathematical definition of diversification, provides clients with diversified core exposure, in equity and fixed income markets. A research driven, Solutions division (TOBAMSolutions®), dedicated to build customized solutions and services to sophisticated institutional investors, A LBRTY® strategy range, which aims to help investors substantially mitigate their exposure to autocratic regimes in their portfolio. In line with its mission statement and commitment to diversification, TOBAM also launched a satellite activity (CRYPTOBAM®) on cryptocurrencies in 2017. TOBAM Maximum Diversification®, TOBAMSolutions®, TOBAM LBRTY® and CRYPTOBAM® illustrate TOBAM’s systematic “out of box” dedication to demanding investors. TOBAM manages USD 2 billion (as of 31December 2024). Its team includes 31 finance professionals based in Paris, New York and Dublin. For more information, please visit www.tobam.fr or tobamdirect.com CONTACTSParis 24-26, Avenue des Champs-Elys ées75008 Paris France Dublin New York Client Serviceclientservice@tobam.fr