The biggest threat to high-flying stocks may be the bond market, research firm says

• A jump in bond yields might be the biggest threat to stocks, Ned Davis Research says. 
• Investors fret over concentration risk, but the entire market is looking expensive, NDR said. 
• That means that all stocks, not just the mega-cap leaders, are at risk if bond yields spike anew. 

Investors have been growing concerned about threats to richly valued mega-cap stocks as concentration grows, but the biggest threat to equities might be lurking in the bond market, according to Ned Davis Research. 

In a note to clients this week, analysts Ed Clissold and London Stockton note that while concentration risk is a valid concern, it isn't unusual for a handful of stocks to buoy the broader index. 

"Outperformance from mega-caps is not bearish unless the rest of the market is declining, which has not been the case recently," the analysts wrote, adding that they agree that it is the case that the biggest stocks could fall the most if valuations correct. 

However, mega-cap concerns "should not let the rest of the market off the hook," they said, and stock apart from the top names also looks expensive. In that context, the biggest threat to stocks may not be specific to any industry or company, but rather the top risk may be another surge in bond yields. 

"Before 2022, high equity valuations could be explained by TINA (there is no alternative to equities)," they wrote.  "[However,] a 16-year high in the 10-year Treasury yield means that stocks are no longer cheap versus bonds, a.k.a. TARA (there are reasonable alternatives to equities)."

They note that the steady decline in the 10-year Treasury yield since last October has made stocks attractive relative to bonds, but a fresh resurgence in government bond yields would hurt the broader market, not just the mega-cap leaders. 

"A backup in bond yields would put more pressure on equity valuations, not only for the top 10 stocks, but also for many others that are trading at elevated P/Es."

The top 10 companies by market capitalization — consisting mainly of the AI-fueled tech stocks that comprise the Magnificent Seven — account for a near-record 33.2% of the S&P 500 market value, but the Ned Davis team said they "put valuation worries in the middle" and some of these may be misplaced.

"The median P/E of the top 10 stocks is 2.6 standard deviations above its long-term mean, while the bottom 490 is 1.8 standard deviations above. The biggest stocks are more overvalued, but to call the market outside the top 10 cheap is being generous."