The U.S. stock market rally this year is so narrow that the S&P 500 index's gains have been entirely driven by just a handful of stocks, which are now significantly more expensive than more than 95% of the broader market.

The question for investors is, does that valuation chasm begin to close, and will it influence the market's direction in the second half of the year as much as it did in the first?

While the gap is extreme, the short-term correlation between valuation and performance is minimal unless you are coming off the sidelines and allocating fresh capital, analysts say. Performance over the next year or so will likely be driven by other factors like positioning and interest rate moves.

Some of the numbers, however, are so startling they cannot be ignored.

The top four stocks in the S&P 500 by weight — Apple Inc., Microsoft Corp., Amazon.com Inc. and Nvidia Corp. — account for almost 19% of the index's entire $34.4 trillion market cap.

They are up more than 45% this year, while the other 496 are up barely 2% and the index as a whole is up less than 8%.


EXTREMELY EXPENSIVE

According to Tajinder Dhillon, a Refinitiv analyst, the aggregate 12-month forward price/earnings (PE) ratio of the top four stocks is 31.6, compared with 16.4 for the other 496 companies and 17.9 for the index as a whole.

Keith Lerner, co-chief investment officer at Truist in Atlanta, calculates that the four stocks' average 12-month forward PE ratio is around 42.0. That compares with the 10-year average of 49.6, and is only lower thanks to Amazon. The other three are all more expensive than before.

The average 12-month forward PE of the other 496 stocks is around 20.8, Lerner says, adding that a "harmonic" valuation measure stripping out extremely low index weightings and high PE readings reduces it further to 16.3.

Whichever way you cut it, the mega stocks are extremely expensive relative to the rest of the market. The cheaper rump of the market that has essentially flatlined this year should be well poised to pick up the baton.

This may play out if the Fed can engineer an economic 'soft landing'. Unemployment at a 50-year low and inflation cooling to a two-year low strengthen the soft landing argument, but caution is still trumping adventurousness.

"When you look below the surface the picture changes from very expensive to more reasonable valuation, but it still might not be compelling enough relative to the above-average macro risk," Lerner said.

CROWDED TRADE

These risks are real and growing — the U.S. debt ceiling standoff, turmoil in the U.S. regional banking sector, deteriorating credit conditions, and the cumulative hit to activity from 500 basis points of rate hikes in little more than a year.

Analysts at JP Morgan point out that, as a share of total shares outstanding, tech has the lowest short interest across U.S. equity sectors, with funds adding to their net exposure to tech in recent weeks.

Everyone wants a piece of Big Tech, from central banks to mom & pop investors in their 401(k) accounts, for myriad reasons — safety, liquidity, an interest rate and valuation play, a bet on artificial intelligence, or a nod to ESG.

Apple is turning into a bank too, offering 4.15% on savings accounts.

It is a top-heavy market. Over the last decade Bank of America's monthly global fund managers surveys have often had various cuts of "long U.S. tech stocks" as the most crowded trade, but April's survey for the first time ever had "long big Tech."

The potential upside is more visible in cheaper sectors that have not participated much in the rally — pretty much everything other than Big Tech — and that are more likely to benefit from a "soft landing." They could include small caps, cyclicals like financials, materials, and some industrials and energy stocks.

Todd Jablonski, global head of multi asset investing at Principal Asset Management, agrees that mega tech is expensive, and he is underweight U.S. and global equities. He prefers fixed income over stocks by a considerable distance.

But within equities he holds a tactical overweight position in large caps even though they are expensive, because of their relative stability and low standard deviation levels.

"It's going to require a broader market participation to drive the next leg higher," Jablonski said, adding that he does not see it happening this year.

(The opinions expressed here are those of Jamie McGeever, a columnist for Reuters.)