February 23, 2021
One of Those Times
Please read important disclosures HERE.
February 23, 2021
Please read important disclosures HERE.
The stock market serves a very important function in our society, helping to steer excess savings (capital) to its most productive uses and ultimately contributing to faster economic growth and rising living standards. Most of the time, the stock market is reasonably effective in this role. Occasionally, however, the market’s capital allocation mechanism seems to break down as excessive investor optimism or pessimism drives the prices of certain stocks and sectors to extreme levels that are largely disconnected from their underlying fundamentals. This appears to be one of those times.
In the current market, signs of excessive optimism are easy to spot. Tesla’s eight-fold price increase last year and further gains this year have increased the company’s market value to a level that only makes sense under the most optimistic future scenarios. Observing the extreme price volatility of GameStop and AMC Entertainment, it is apparent that most buyers and sellers of these stocks have given little, if any, consideration to the companies’ long-term prospects.
At the aggregate market level, record levels of margin interest (the amount that investors have borrowed against their investment accounts) suggest excessive investor optimism, as does the volume of initial public offerings (IPOs). A record number of IPOs were completed last year, with more than half consisting of companies called SPACs,1 which were formed for the sole purpose of merging with another, yet-to-be-determined company. In the past, periods of excess bullishness tended to coincide with high numbers of new offerings, as private investors took advantage of the frenzied atmosphere to cash in.
The triple-digit gains in some stocks and the record IPO issuance are reminiscent of the tech bubble of the late 1990s. Back then, many of the extreme highfliers such as Pets.com and Webvan were associated with a technology we then called the “World Wide Web” but now call the “internet.” Today, we’re observing similar excitement around companies associated with electric vehicles and clean energy.
Not Just a Few Highfliers
The exuberance in today’s market is not limited to just a few highfliers with questionable prospects though. Investors have also bid up the prices of the huge, profitable tech companies, including Apple, Microsoft, Amazon, Alphabet, and Facebook. Together, these five companies’ stocks averaged a 53% gain in 2020, which was substantially greater than the growth in their earnings2 and much higher than the gain in the broad U.S. stock market.
Here too, we see parallels with the tech bubble of the late 1990s. Back then, as dot-com stock prices were going crazy, the prices of many of the larger, profitable tech stocks were also increasing substantially, ultimately reaching levels that turned out to be unsustainable. These large tech stocks, including Cisco Systems, Microsoft, and Intel, dominated the NASDAQ Composite Index,3 which declined by 78% in the two-and-a-half years following the bursting of the bubble in early 2000.
As in the late 1990s, the big tech stocks have recently become an increasingly large portion of the major stock indices such as the S&P 500.4 The following chart shows the portion of the S&P 500 comprised of tech stocks since the early 1990s. Technology and other new economy stocks now comprise 41% of the S&P 500, exceeding even the level reached at the top of the tech bubble in 2000.
What Inning Are We In?
The above chart appears to suggest that we are close to the top of the current market cycle and that the current exuberance for the popular stocks and sectors is likely to end soon. However, this isn’t necessarily the case. While we’ve observed parallels with the last tech bubble, there are also differences. One important difference is that the current U.S. stock market, while quite expensive based on key valuation metrics such as the cyclically adjusted price-earnings (CAPE)5 ratio, has not yet reached the extreme valuation levels of the late 1990s. To reach the CAPE ratio of 44.2 that the S&P 500 attained at the end of 1999, the index would have to rise another 29% from year-end levels. Additionally, interest rates are much lower today than in the late 1990s, which arguably justifies today’s higher valuations to some extent. Ultimately, since no two historical periods are identical, we are limited in the inferences we can draw from past experiences.
History has also taught us that expensive stocks can remain expensive for years before their prices eventually revert to more normal levels. Moreover, successfully predicting when the cycle will turn is extremely difficult. It is very hard to know whether we’re in the ninth inning of the current cycle or whether we still have several more innings to go.
How to Navigate
Given the uncertainty as to when the current cycle will turn and the major role technology stocks play in the economy and the markets, we recommend continuing to allocate a significant portion of a diversified portfolio to tech stocks. Within the U.S. stock portion of our clients’ portfolios, in general, tech and other new economy stocks comprise about one-third of the total. While this allocation to tech is substantial, it is not as high as tech’s 41% weighting in the S&P 500, as noted earlier.
In addition to maintaining a core exposure to tech stocks, we advocate tilting portfolios to areas of the stock market that aren’t as frothy. We accomplish this by 1) allocating a portion of stocks to value stocks, which are at the other end of the spectrum from the growth-oriented technology stocks and 2) allocating nearly a third of overall stock allocations to foreign stocks. Relative to the U.S. stock market, foreign stock markets in aggregate have a much lower allocation to technology stocks6 and a substantially lower valuation based on the CAPE metric.7
By maintaining exposures to more reasonably valued areas of the market, our clients’ portfolios are well-positioned to earn solid long-term returns from their stocks even as the U.S. stock market in aggregate looks increasingly expensive.
One final thought. As pandemic-related restrictions have continued to limit traditional leisure activities, some have turned to the stock market for entertainment. There is nothing inherently wrong with treating the market this way as long as investors don’t confuse entertainment with serious investing. Just as with gambling, a trip to the casino should not be considering investing, and gamblers should only bring the amount of money they are willing and able to lose. Individuals considering purchasing today’s highfliers should adopt a similar mindset.
*The sources for this article are Morningstar and Yahoo Finance unless noted otherwise.
1 SPAC stands for special purpose acquisition company. Per Jeremy Grantham, founder of GMO, there were 480 IPOs in 2020 of which 248 were SPACs.
2 These five companies’ earnings per share grew by an average of 25% in 2020 based on actual results through September and estimates for the fourth quarter.
3 NASDAQ Composite Index: A market capitalization-weighted index of common equities listed on the Nasdaq stock exchange. The index includes all Nasdaq-listed stocks that are not derivatives, preferred shares, funds, exchange-traded funds (ETFs), or debenture securities. An index is unmanaged and not available for direct investment.
4 S&P 500 Index: A market capitalization-weighted index that generally contains the 500 largest publicly traded stocks in the U.S., subject to certain restrictions. An index is unmanaged and not available for direct investment.
5 Per data from Yale economist, Robert Shiller, the CAPE ratio of the S&P 500 was 34.3 as of 12/31/20. This was its highest level over the past 100 years with the exception of the tech bubble in the late 1990s.
6 Technology and other new economy stocks comprised 22% of the MSCI ACWI ex USA Index, a broad index of developed and emerging market stocks, as of 12/31/20.
7 Per data from Research Affiliates, the CAPE ratio of the MSCI ACWI ex USA Index was 18 as of 12/31/20.