23 July 2020


By Raul Elizalde

This article also appeared on forbes.com

The idea that the stock market is reaching dangerous levels of overvaluation is making the rounds. Comparisons with 1999 and the run-up to the dot-com bubble burst are common. But it may be a mistake to draw conclusions about “the market” at a time when broad measures of valuations are distorted by a handful of big names that dominate the index.

Just five firms – Alphabet, Amazon, Apple, Facebook and Microsoft – account for 25% of the S&P 500 market capitalization, a gauge comprised of 500 large-cap U.S. stocks. Their share more than doubled since 2016, when the same firms represented just 12% of the value of the total index.

Market concentration is neither new nor necessarily a bad sign. IBM alone often accounted for more than 6% of the market in the early 1980s, at the beginning of a monster rally that saw the S&P 500 grow tenfold. The risks lie in whether the conditions that brought about the rise of these five “stars” will persist. One way of addressing those risks is not to liquidate but to consider opportunities that may lie elsewhere. The recent attempts at rotation to other areas of the market may have been early, but stocks and sectors that took a beating during the pandemic may deserve a serious look.

Stripping away these five stocks from the index gives a better idea of what the other 495 are doing. While the market capitalization of the five giants grew at an annual average of 30% from the end of 2017 through the end of last quarter, the rest of the market did so at a comparatively paltry 3%. This is not unjustified, since the winners’ red-hot income performance compares poorly against the rest: Operating Income, for example, expanded by 13% in that period while for the rest it shrank by 4%. The discrepancy is even larger when comparing income from continuing operations. Table comparing market cap of five technology firms against the rest of the S&P 500.

source: Path Financial LLC, Macrotrends, S&P Dow Jones Indices, NASDAQo
The way these firms dominate the aggregate numbers is considerable. An 8% annual return for the S&P 500 seems high for just three years, considering the hit that the economy took from the pandemic, but 3% without the star performers makes more sense. True, even this may seem high when both operating income and GAAP income went down for the rest of the market in the period, but this group also includes the energy sector for which the 4-quarter trailing GAAP income sank from $18/share at the end of 2017 to -$41/share at the end of last quarter. These factors suggest that although aggregate measures make the market seem expensive, a more granular analysis reveals that investors are not blind. The market seems fairly priced.

The market cap increase of the five “stars” seems in line with their income growth, which benefited from a trend where more and more of the economic activity was moving online and was then turbocharged by the pandemic. Certainly shopping and higher-paying jobs have migrated that way, and the proliferation of food delivery services shows that the trend is broadening. One question is whether these changes are temporary or permanent. The way the market capitalization of those stocks ballooned indicates that the market increasingly believes the latter.

The risk that this portends carries a good deal of irony. On one hand, defeating Covid-19 will be cause for universal celebration. The economy could then get back to normal, not to mention the relief in terms of human lives. But if people return in droves to shopping malls, offices, airports, restaurants and hotels, the current market leaders could suffer a big blow if investors drop them in pursuit of opportunities elsewhere. Plenty of stocks and sectors are still in the dumps.

A big decision for market participants, then, is whether to keep riding what seems to be an unstoppable technological wave or to start moving towards sectors that were hit hard during the pandemic. The latter is also risky, since trends have a way of lasting longer than most think possible. An obvious example of this is the return to lockdowns in many areas in the U.S. as a response to the steep surge of cases, hospitalizations and deaths. It seems that the tentative start of a market rotation in the last few weeks may have come too early.

IPO activity, to be sure, offers mixed signals about where the market sees that trend heading. Both Doordash, a food delivery company that relies on people craving restaurant food but who don’t want to leave home, and Airbnb, a company dependent on leisure travel, managed to raise large amounts of money. It is possible to imagine a world where both can be successful, for example if people start traveling again but eat at their vacation rental homes’ kitchens instead of going out. This is not unrealistic, but it demands quite a bit of optimism.

That optimism is not only evident in those IPOs but also at the recent Bitcoin rally or the recent, somewhat odd investor rush to buy of entire libraries of hit songs. These could be signs of a market overheated, but they could also reflect a lack of investment options at a time when cash is sloshing around aplenty. The latter is a better explanation, and it doesn’t look like it will end anytime soon.

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