When it seems there is only one game in town

Strong earnings growth (blended S&P 500 earnings per share (EPS) growing almost 30% year-on-year) and a partial unwind of geopolitical risks in the Middle East were the supporting factors behind the market strength. Yet the breadth of the market remains very narrow – fewer than 30% of S&P 500 constituents actually outperformed the S&P 500 Index during the second quarter.

Market returns continued to be supercharged by an exceptionally concentrated artificial intelligence (AI) trade, with semiconductor (up 55% in the quarter) and hardware (up 29%) companies contributing almost 60% of the MSCI World Index's total return during the quarter.

This narrow strength is making concentrated markets even more concentrated. Semiconductors and hardware now account for 30% of S&P 500 market cap, up from around 10% pre-pandemic and above the dotcom peak of 24%.

Capital flows have become similarly concentrated, with increasing retail participation and the growth of leveraged investment products directing an ever-larger share of each incremental investment dollar towards the same small group of AI infrastructure stocks, reinforcing momentum in an already crowded trade.

This concentration is not without earnings support, but the question for any long-term investor is whether those earnings reflect a durable step-change in industry economics or a temporarily favourable point in the cycle. Take memory, for example: Bloomberg’s Memory Exposed basket rose more than 130% during the second quarter as DRAM¹ and NAND² prices continued to surge. After 18 months of rising prices and constrained supply, operating margins across parts of the industry have moved from what has historically been a 0%-30% through-cycle range to 70%-80% − levels that exceed those typically achieved by even the highest quality software businesses.³ Economics this attractive inevitably encourage new investment and, in a largely commoditised industry, periods of exceptional profitability have historically proved self-correcting as additional supply (in this case potentially from China) catches up with demand.

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