Over the past few months, I’ve been hearing this question a lot. It was first asked in March, when the markets were in a free fall, and then again when they started to climb in April. The question is a really good one, but it requires us to look under the hood a bit to see what’s going on. First of all, keep in mind that stock markets reflect future expectations about the economy and company profits, not current conditions. We wrote about this phenomenon in detail a few months ago in Climate Versus The Weather.
When we start really looking “under the hood,” we see two clear markets out there: big-tech and the rest of the global market. One of the most popular stock market indices is the S&P 500, which represents the 500 largest companies in the US. Keep in mind that the US has over 3,000 stocks, so this is just the largest 500. The index is a market cap weighted index, which means the largest companies in the index get the most weight. So today, if you put $500 in the index, you would not be putting $1 in each company, you would be putting $5 in Apple (the largest company in the index), and maybe $0.25 cents in company 500. Really, $500 in the S&P 500 today means almost $150 in the top 15 companies and $350 in the other 485 companies.
So why should you care, as long as it’s going up? The answer is simple. It’s all about valuations. Right now, the biggest 15-20 stocks are moving the entire index forward; however, 70% of the stocks in the index are still negative for the year. Virtually every industry is still negative outside of the large tech companies. We’ve seen this trend before. In 1999, a handful of tech names dominated the index, so buying the index at that time meant buying a few stocks at nosebleed valuations. The same is true of today’s index. To put it in perspective, here are some interesting facts about what is going on with the markets and in some particular stocks:
- Apple – Apple is a great company, no doubt, but today its valuation is greater than all of the German stock market. Keep in mind that Germany is the 4th largest economy in the world, coming in behind only the US, China, and Japan. German companies include SAP, BMW, Volkswagen, and the like.
- Tesla – Here is a company that has never made any money without government subsidies. They showed a profit for the last year, but that was from selling solar credits (basically a government subsidy), and they still lose money on every car they sell. This is still a low-margin manufacturing business. However, Tesla today is worth more than the entire US and Korean auto industry with BMW thrown in for good measure. Tesla sells less than 1% of the cars that these companies sell, but their market valuation is more than all of them combined. They are burning through cash, and they just announced that they are selling billions in shares, as their price is so high. This action means they are diluting their existing shareholders, and the price is going up! It’s totally illogical.
- A ratio called the S&P 500 to GDP shows the value of the S&P 500 to the value of our economy (GDP – gross domestic product). Today, the S&P 500 to GDP is 132%, which means the 500 largest companies are worth 132% of the entire economy. We’ve only seen this phenomenon once before in recent memory, which was in the year 2000, before the tech crash that preceded 10 years of brutally low returns in the index.
- US tech is now worth more than all the stocks in the Euro zone. Keep in mind that the Euro zone includes the UK, France, Switzerland, Germany, etc. The Euro zone is the same size economically as the US, with the same population.
- Stocks like Netflix, Amazon, etc. are all great companies, but they are selling at multiples 100x their earnings. Markets historically price companies at 15-20x their earnings.
- US stocks are now more expensive compared to European stocks than they have been in over 100 years. We haven’t seen such a crazy valuation difference since then. Keep in mind that the Euro zone has not contracted economically as much as we have during this pandemic, either.
- Over the last few years, a huge difference has developed between growth and value investing (again, due to large tech). This difference is the widest and largest it has been in almost 20 years. Typically, such a large difference between value and growth means that value tends to take the helm with returns for a number of years.
Ok, so what does all this information mean? For one thing, there is no way to know when these trends will reverse; it’s not like a light switch that flips off. However, we do know that nothing goes on the same way forever, including stock markets. I know I sound like a broken record, but this all means diversification is more important than ever. We certainly need to own these tech stocks, and in general we should have 10-15% of our US portfolio in them, but any more than that is extremely risky. Secondly, and more importantly, it means we have opportunities outside of large tech. Seventy percent of the stocks in the US and overseas are still down, so those present a great opportunity for long term investors.
As always, we are here to answer any questions you may have!