The last decade has been a strong one for U.S. equities and bonds. One primary driver of that performance were low starting valuations, stemming from the Great Recession, which had just ended in 2009. This was the opposite of the scenario that led to the lost decade preceding it. I believe many market participants are setting the table for a future lost decade by chasing short-term performance and ignoring valuations.
On January 3rd, 2000, the S&P 500 traded at 1455.22. Valuations were extremely high, as the Tech Bubble was still in full force. 10 Years Later, the S&P closed at 1115.1, representing a completely lost decade for U.S. stock indices. Of course specific stocks did very well, but even the bellwether names such as Microsoft, Cisco and Intel, faired very poorly, despite strong earnings growth over the decade. Other asset classes such as Emerging Markets and European stocks held up much better, as they came into the period at much more reasonable valuations. Paying too much, even for great companies, can lead to very poor returns.
After the Tech Bust and the Great Recession occurred over a 10-year period, investors entered the following decade with a gun-shy approach to equities. Other sectors such as commodities like gold/oil, or alternative assets such as REITs/MLP’s, were becoming more popular. Fast forward eleven years, and the S&P 500 has risen from 1115.1 to 3703.06. The pessimism reflected in prices going into the period drove stronger investment returns, while the optimism and high valuations from 2000 drove the poor returns.
Despite the Covid-19 pandemic, associated lockdowns and substantial recession, equities once again are priced with immense optimism. Technology stocks once again are leading the way like they did into 2000, as companies such as Apple, Amazon, Zoom, and Netflix benefited when many other areas of the economy were shockingly closed down. As these companies have grown in size, the S&P 500 has become more concentrated among the top names than it has ever been. This has helped index fund investors as these stocks outperformed the average stock and especially value stock, by a large margin this year.
As you can see from the table above, the top 30 weighted names in the S&P 500 represent 43.947% of the weighting on the S&P 500. We took the forward earnings multiple of all 30 of these names and the average was an absolutely staggering 33.86. This is about double the normal historical multiple on forward earnings; and keep in mind that earnings expectations anticipate a rapid recovery in corporate earnings as the economy rebounds from the sharp contraction we experienced in 2020.
There are some notable outliers in that top 30, on both the rich and the poor side in terms of valuations. Amazon, Tesla, Netflix and Salesforce.com, headline the most expensive names. AT&T, Pfizer, Bank of America, JPM, and Merck highlight some of the cheaper names. What I find most striking is just how expensive the average is. The two leading components Apple and Microsoft each are worth around $2 trillion, which is by far the biggest in the world, yet they trade at 30 times forward earnings. That is roughly double what they have traded around for most of the last decade using the same metric, when they were growing faster than they are expected to grow over the next decade. Now stock valuation is far more sophisticated than simply looking at one metric such as the forward earnings multiple, but that is an important indicator to check the temperature of the market. Mean reversion is a powerful tool, and it would only take a little on the biggest names to drive the indexes lower. Conversely, stocks trading cheaply, largely due to the chaos of 2020, offer much more attractive opportunities for future positive mean reversion as the economy normalizes.
Many market participants are looking at the index returns over the last decade and assuming that makes sense to invest in them over the next decade, but ignoring starting valuations is a perilous mistake. Focusing on the individual companies that present opportunities gives us a great opportunity to profit with a far lower risk profile. It isn’t surprising that some of the more inexpensive names in the indices are found in our portfolios. In our next article, I’ll talk about some of those specific opportunities and why we believe they are poised to really be profitable endeavors. I also think not piling into overvalued indexes and stocks will be immensely important to preserving and growing our capital over the long-term, as there are many signs of bubbles forming, which can be tempting, but usually lead to tears in the end.