Year to date, the S&P 500 is up ~15%. The primary reason for this is that the index has been dragged up by just a few mega-cap stocks namely Microsoft, Nvidia, Apple, Amazon, Meta (Facebook), and Alphabet (Google).

The S&P500 tracks 503 of the largest and most stable publicly traded companies. However, it is weighted by market capitalization, which means larger companies have more influence over the performance of the index.

For context, the total market capitalization of all 503 stocks in the S&P 500 is ~49 trillion. However, just the six stocks listed above constitute a whopping ~30% of the entire index. Just one stock, Nvidia, is responsible for > a third of the S&P’s advance this year. The point is, if you don’t own Nvidia, more than likely you are dramatically underperforming the S&P500.

Despite the year-to-date surge in the S&P500 and other AI-themed stocks, the guts of the market do not trade well. Indeed, a few stocks are distorting the health of the overall marketplace. For instance, The S&P 500 equal weight index tracks the same 503 largest and most stable publicly traded companies, but each constituent counts the same regardless of size; it is only up ~4%. The well-known Dow Jones Industrial Average is up only marginally. The Russell 2000 Index which tracks small and midcap stocks is ~unchanged for the year.

According to Bloomberg, "The Russell 2000 Index is underperforming the S&P 500 Index by nearly 15 percentage points so far in 2024, putting the gauge for small-cap shares on pace for its worst first six months to a year ever versus the broader benchmark."

AI Stocks

In many instances the hype around AI is warranted. AI will be a tremendous value-enhancing productivity tool that businesses across many industries will incorporate into their internal operations and external offerings.

AI stocks have gone parabolic over the last few months. If you happen to own them, kudos to you. If you don’t and are considering buying now with the expectation of reaping short-term gains, consider a brief history of investing in stocks of new technologies that promised and did exponentially raise productivity and ultimately drive the profits of many companies that harnessed the technology meaningfully higher.

• The Telegraph: In the 1840s, Samuel Morse (think “Morse Code”) demonstrated that he could send information via copper wires. People were amazed; America caught telegraph fever. A bunch of telegraph start-ups vied for a piece of this hot new technology. In less than 10 years, the number of telegraph miles in America rose by a factor of 10. A massive supply glut and a brutal price war ensued. Almost all the telegraph start-ups went bankrupt. The ones that muddled through as well as the existing firms who pivoted towards this new technology suffered through a brutal bear market. However, the telegraph did indeed bring massive productivity gains. Information could be sent cheaply and quickly. National news agencies such as the Associated Press (AP) were formed, stock data could be transmitted in real time, and money could be sent/ received (almost) instantly via wire with innovative companies that harnessed the power of the telegraph such as Western Union.

• Railroads: After the Civil War, America went on a railroad construction binge. In the 1880s, over 70,000 miles of rail were constructed – mostly financed by debt - doubling the existing total. Railroad and related stocks went crazy. However, all these new tracks created network redundancies. Railroad Co’s responded by cutting freight rates aggressively to maintain market share. In 1894, the railroad bubble burst; ~one-quarter of all railroads went bankrupt. The publicly traded ones that survived suffered dramatic share price declines. However, plummeting freight rates allowed consumer products to be moved across the country cheaply. Montgomery Ward and Sears were born. National brands (Coke, Procter & Gamble, etc) were established.

• Fiber-Optic/Internet: In the 1990s companies including Global Crossing and Worldcom spent tens of billions of dollars laying almost 100 million miles of fiber-optic cables underground. The internet age had arrived, and fiber-optic cable along with internet routers and switches made by a company called Cisco would represent the plumbing or backbone of the internet through which all digital data would travel. Consumer companies such as Peapod, Webvan, and Amazon raised billions of dollars from investors looking to cash in on the Internet. Everybody wanted in. However, by 2001 less than 10% of all this new fiber-optic capacity was being used. The result was a massive supply glut which resulted in price wars and a crash in fiberoptic and internet stocks. The Nasdaq collapsed by over 80%. Numerous companies including Global Crossing, WorldCom, Peapod, WebVan, and many more went bust. The companies that survived, including Amazon, Qualcomm, Cisco and more all saw their share prices decline ~90%. However, all this new fiber-optic infrastructure built during the bubble years did lay the foundation for the Internet. By 2006, over 40% of American homes had high-speed internet access (broadband). Today, over 80% do and ~95% of Americans are “online.” Everyday millions of Americans buy, sell, bank, and more, online. Worth noting, it took Amazon ~10 years to reach and surpass its stock price from March of 2000. Those who bought shares of Cisco during the internet boom and are still holding today are (still) down ~66% in real terms.

Back to AI stocks: Yes, AI will (eventually) make people more productive, help expand margins, and drive profitability. But remember, so did the internet, railroads, and the telegraph. Many stock market darlings in each respective genre went bankrupt and/ or were acquired for pennies on the dollar. The companies that survived suffered dramatic share price declines before recovering and making new highs.

Valuation

The stock market is fundamentally expensive. Currently, it trades at a price-to-earnings ratio of ~24x vs an average of < 20x over the proceeding 12 years. On a price-to-book metric, the market is trading at 5x book value vs an average of 3.60x over the last 12 years. The cyclically adjusted price-earnings ratio, or CAPE, is an eye-watering ~36x. The CAPE ratio is designed to provide a long-term perspective of market valuation. By using a 10-year average of earnings, it adjusts for year-to-year cyclicality in corporate profits, offering a more stable measure than the traditional price-earnings (P/E) ratio.

Since it was made popular by Yale economist Robert Shiller, the CAPE has been higher than it is now on two occasions: in 2000 just before the internet bubble burst and in 2022 when equity markets sold off ~25% before pairing some of those loses later that year.

An expensive stock market portends lower-than-average returns in the coming years. However, predicting stock market movements based on valuation alone is incredibly challenging and not a good idea. The reason is that high valuations can sometimes subsist for longer than most people believe they can.

Many pundits argued that the stock market was “overvalued” on December 5th, 1996, when Allan Greenspan delivered his now famous “irrational exuberance speech.” However, it wasn’t until the year 2000 that the internet bubble popped. The point is that selling stocks on valuation alone can mean missing out on substantial gains because often the last move(s) up before a correction is parabolic.

At some point the market will suffer a material correction; that is a foregone conclusion. However, discerning from where the market will correct is fiendishly difficult; because markets tend to stay overbought and or get even more overbought (to suck investors in)…until they ultimately correct (and spit investors out).

The Name Is Bond…Government Bond

At this juncture in the economic cycle, one might consider purchasing U.S treasury bonds to hedge against an overvalued stock market – that might (or might not) become even more overvalued.

I believe the Federal Reserve will cut interest rates this year, but why? Will the cuts come courtesy of lower inflation while the economy hums along swimmingly – which would be bullish for stocks and bonds - or will the cuts be because the economy begins to slow – which would be bearish for stocks but bullish for bonds? My best guess is that the answer is both; with the initial cuts being in response to lower inflation and further cuts being in response to slowing economic growth. U.S. bonds should outperform in either of these scenarios.

If the stock market continues to rise, U.S. bonds can still work. The reason is that regardless of what the economy does, inflation is receding, albeit in fits and starts. Inflation is currently running at 3.3% annualized, down from a peak of 9.1% in June of ’22, and relatively close to the Federal Reserve’s 2% target. As inflation continues to decline, bond yields should follow (bond prices move inversely to yields).

A primary risk in owning U.S. bonds is if the economy enters a period of stagflation. Stagflation is rare. It occurs when an economy slows, unemployment rises, inflation rears its ugly head, and interest rates rise. (Normally, when the economy slows and unemployment rises, inflation recedes, and interest rates drop).

Anything could happen; but I believe the probability of entering stagflation is extremely low. When stagflation takes place, usually the primary culprits are high energy prices and high inflation expectations which lead to a Wage-Price Spiral.

The last time stagflation took place in the U.S. was in the 1970s. Back then, America was heavily dependent on Middle Eastern countries for oil and OPEC controlled its price. Today, OPEC still matters but the United States now produces the most oil (and natural gas) in the world. Hence, the odds of a sustained spike in oil prices as we witnessed in the 1970s are low. If production is curtailed in the Middle East (on purpose or because of geopolitical strife) producers in the U.S. will act nimbly and take advantage of higher prices by ramping up production which will bring the price back down. The cure for high energy prices…is high energy prices.

Furthermore, comparisons to the energy-induced inflationary shock of the 1970s and suggestions it portends a long period of elevated inflation are inappropriate. Unlike in that era, America is not a highly energy-intensive nor dependent economy today.

Over the last four decades American economic output expanded by ~300%, however energy demand grew only ~50%. To help put these figures into context, consider the following data compiled by the bipartisan, Alliance to Save Energy:

“On a per capita basis, U.S. energy productivity and efficiency gains have muted the growth in energy use that might be expected as Americans have become more prosperous. Despite the growth in average home size, more and bigger vehicles driven more miles, and the rapid growth in all kinds of energy-consuming devices, from air conditioners to computers to air travel, energy used per American has decreased over the last several decades”

Wage-Price Spiral

In a Wage-Price Spiral, high inflation expectations lead to higher wage demands, which businesses pass on as higher prices, creating a feedback loop of rising wages and prices.

Despite what you read in the papers or online, inflation expectations are well anchored. We know this because financial instruments exist that represent investors’ expectations for the rate of inflation for various durations in the future. The granularity of how these figures are compiled goes well beyond the scope of this post. What is important is this: Investors believe that in 24 months inflation will be just ~2%. This data is simply not indicative of a coming wage-price spiral. If anything, that happened in 2022 when the CPI was running close to 9%.

Disclaimer

*The material herein is provided for informational purposes only and should not be construed as investment advice.