The Year of the 493?

Is this the year of the 493?

The 493? Here we refer to the 493 stocks of the S&P 500 — the 493 stocks not named Apple, Microsoft, Google, Tesla, Nvidia, Amazon or Meta.

These are the seven wagon-pullers that have hauled the stock market to present extremes.

The S&P 500 galloped 24% last year under their behemoth influence.

The remaining 493 lagged far behind them.

Mr. Michael Lebowitz of Real Investment Advice:

[2023’s] most popular investment bandwagon [was] the Magnificent 7, comprised of Apple, Microsoft, Google, Tesla, Nvidia, Amazon and Meta… These seven stocks gained 71%… while the remaining 493 stocks added a mere 6%. The outperformance pushed up their contribution to the S&P 500 to nearly 30%. Lastly, the sharp increase in stock prices led to even more extreme valuations for the group…

As we enter 2024, be open to the possibility that last year’s winners will not take the crown this year. 

We are indeed open to that alarming possibility.

Off the Charts

A low P/E ratio indicates stocks are cheap. A high P/E ratio indicates stocks are dear.

The lower the valuation… the higher returns investors can expect across the next several years.

The opposite likewise holds true. Elevated valuations imply diminished returns across the next several years.

A P/E ratio of 17 is about par… as history runs.

That is, P/E ratios below 17 indicate stocks are cheap. Above 17 stocks are expensive.

What is today’s P/E ratio for these Gargantuas?

S&P Global informs us that the current ratio for these stocks registers a galactic 42.8. — some 2.5 times par.

Investors in these stocks are offering to shovel up $42.80 for each $1 of earnings. Handsome!

If the term “mean reversion” has anything in it — we believe it does — these investors are in for a good whaling.

A Negative 18.6% Return?

The technology sector’s overall P/E ratio presently flies along at 33.

If their ratios remain unchanged, S&P Global informs us these stocks may leap 25.2% this year.

Yet what if these ratios revert to their 2022–23 average?

These stocks may merely yield 8.2%.

And if their P/E ratios retreat to their 2017–19 averages?

These market makers may yield -18.6%. That is, negative 18.6%.

Thus the market pushers would become the market pullers.

The stock market’s colossal assets would become its colossal liabilities.

And the hordes that flocked into them would as rapidly flock out of them.

Would the remaining 493 stocks of the 500 assume the locomotive’s controls… and power the freight train on?

It is possible. Yet which ones?

If they now must be pulled… how could they push?

The Broader S&P

Let us consider the S&P 500 in the aggregate. Its combined P/E ratio presently reads 24.6.

That ratio tracks far beneath the Magnificent Seven’s 42.8 and the technology sector’s 33 average.

Yet recall: 17 is par. Thus the S&P 500 is overvalued by this metric — not fantastically overvalued — yet overvalued.

It represents no bargain at the going price.

Recall, elevated valuations today indicate depressed stock prices tomorrow. Mr. Mark Hulbert of the eponymous Hulbert Financial Digest:

If the stock market is to break out to record highs, as some exuberant bulls are predicting, then it will have to look elsewhere than valuations for support. That’s because the S&P 500 now is almost as overvalued today as it was at the bull market’s January 2022 high, despite last year’s bear market. This is both unusual and disappointing, since the typical pattern is for a bear market to largely work off the previous bull market’s excesses — thereby creating the preconditions for a major new bull leg.

Shall we now turn to Mr. Warren Buffett and his famous indicator? What would Omaha’s sage say?

“Significantly Overvalued”

The Buffett Indicator is simply the ratio of total United States stock market capitalization to the gross domestic product.

A reading below 1 indicates a stock market undervalued against the economy underlying it.

Stocks are steals.

A reading of 1 indicates a stock market and economy marching precisely in step, the one the perfect mirror of the other .

A reading above 1 indicates a stock market overvalued against the economy underlying it. Stocks are dear.

This gauge read 2.1 prior to the 2000–01 collapse with its horrific overvaluations in the technology sector.

That is, total stock market capitalization registered 2.1 times GDP.

The Buffett Indicator attained a delirious 2.6 in late 2021 — a record. What does it presently read?

The answer is 1.72.

The gross domestic product hovers at $27.6 trillion. Total stock market capitalization, meantime, runs to $47.49 trillion.

That is, the stock market is “significantly overvalued” relative to the gross domestic product.

A 1.72 ratio does not represent a 2.1 or 2.6 lunatic derangement, it is true.

It nonetheless represents an overvalued stock market — in Mr. Buffett’s telling at least.

Of course this Buffett Indicator is no crystal sphere. It reveals neither day nor hour of reckoning.

It merely takes the overall view. And the overall view is overvaluation — again, in Mr. Buffett’s telling.

It’ll Take a Near-Miracle

What does an overvalued stock market imply for the following decade? Bloomberg:

A monster 10 years for U.S. stocks has showered money on the buy-and-hold faithful and made virtually every other asset class an also-ran.

So great have the gains been that some fairly simple math shows that however roaring the 2020s turn out to be, reprising the last decade’s bounty will take near-miracle expansions in earnings and valuations.

Will these near-miracle expansions and valuations locate within the 493?

We do not know. Yet we are far from convinced that they will.

Of course it is possible — it is possible — that the Magnificent Seven will rampage clear through 2024 and beyond.

Manias can defy all logic, all sense. And market manias are often the most maniac of all manias.

Yet we cling to our faith in mean reversion. As we have argued before:

Scales balance ultimately, what goes up comes down, what goes down comes up…

The mighty fall, mountains crumble, the meek inherit the earth.

We hazard stock market and economy will meet once again on fair ground.

We further hazard they will meet upon the economic level — not the stock market level.

When? We do not know of course. The answer… as always… is on the knees of the gods.

Perhaps Mr. Powell and mates can hold the sun up in the sky.

Perhaps their tricks can postpone sunset indefinitely.

And perhaps pigs will sprout wings… and take flight…