Understanding the Concentration and Reversal of Tech Stocks in the Market

General Discussion 0 replies 0 votes 1686 views Tags:  concentrationInformation Technology sectormarket dynamicsmean reversionS&P 500technology stocks
anuv javier 9 months

Tech stocks in the S&P 500® Information Technology sector have shown exceptional performance this year, surpassing the broader S&P 500 index by an impressive 26% during the six-month period ending June 30, 2023. This outperformance is primarily driven by the strength of mega-cap companies and is particularly notable due to the narrow breadth of the sector.

Given the concentrated nature of the sector, concerns regarding concentration naturally arise. To measure concentration, the Herfindahl-Hirschman Index (HHI) is commonly used. It calculates concentration by summing the squared weights of the index constituents. A higher HHI indicates increased concentration. However, when comparing the Tech sector over time, an adjusted HHI is utilized, which considers the sector's HHI divided by the HHI of an equal-weighted portfolio with the same number of stocks. A higher adjusted HHI indicates a more concentrated sector, regardless of the number of stocks.

Currently, Tech's adjusted HHI level of 9.6 is in the 99th percentile, indicating an extreme level of concentration compared to the long-term average of 4.9. Looking at historical trends, it can be observed that when concentration has been relatively high in the past, it has tended to subsequently decline.

Another interesting observation is the negative relationship between Tech's change in adjusted HHI over time, as a sign of mean reversion. High levels of concentration in the past have often been followed by a decline in concentration. The recent market regime is rare, with Tech's unusually high change in adjusted HHI of 118% over the five-year period ending in June 2023, compared to a change of 5% in the prior five-year period ending in June 2018.

The tendency for Tech concentration to reverse has significant implications for equal-weight sector strategies. Typically, after periods of concentration peaks, equal-weighted Tech has outperformed its cap-weighted counterpart.

While concerns about concentration may evoke memories of the 1990s tech bubble and pose potential challenges for active managers, it's important to note that today's Tech sector is distinct from that of the 1990s. Furthermore, the role of an index is to reflect the market, and examining historical dynamics helps us understand the various index weighting options available to track specific market segments.

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