Speculators who treat the stock market as a casino love concepts. They are new, unburdened by history, can be projected far into the future, and thus can justify almost any stock price. For those who foist stock ideas on an unsuspecting public, it is a rich vein to mine. Just because the concept may be valid does not mean the investment vehicle is as well.
The concept du jour is artificial intelligence, known as AI. Two weeks ago, a chip firm called Nvidia had their stock go up some 31 percent in a day, making it the third highest valued company on Wall Street. This was in response to a quarterly report that showed earnings going up 12.8 percent. Never mind that the profit increase came from the absence of a 2022 expense item (Acquisition termination cost) of $1.3 Billion and a gain of 8.3 times in investment interest income, and not from operations. In fact, revenues for the quarter were down 14 percent from the prior year, and Gross Profit declined15 percent, a sign of narrowing margins. To those who embrace concepts, these facts are mere details, as is the sale by insiders of $193 million in Nvidia stock over the past year in 44 transactions.
Other details are a bit harder to overlook. Nvidia stock currently sells for about 38 times revenues and 200 times earnings. While the stock is down about 10 percent from its high, it is still sporting a nosebleed valuation. By contrast, the average stock in the S & P 500 sells for 22 times earnings and less than 4 times revenues.
Nvidia is among the five highest valued stocks in the Standard and Poors 500 Index. These top five stocks make up 20 percent of the value of the 500-stock universe, the top ten stocks 30 percent*. Stated another way, the 490 remaining stocks make up 70 percent of the value of the index. The average 60/40 retiree using index funds has about 18 percent of his or her portfolio in these ten stocks. So much for diversification.
This concentration of market value has been increasingly common in the past five to ten years. It has been aided by the creation of index funds which buy whatever is needed to match the weighing of the index. If a stock goes up more than the overall index, the index fund buys proportionally more of it, causing the security to go up more still.
Thus, overvalued stocks become more so, creating a spiral that is usually corrected when enough people realize that the stock’s value is way out of line. Given the popularity of index funds, this can take time. At this writing Nvidia makes up about 2.8 percent of the S & P 500. The largest index holding is Apple at 7.5 percent. Microsoft makes up about 6.9 percent, followed by Amazon at 3.1 percent, with Nvidia rounding out the lot.
Investors of a certain age have seen this movie before. In the 1960s there was the rise of what became known as the “Nifty Fifty” stock list. Supposedly the companies on this list were growing so fast that a current overvalued purchase price could be rectified with the passage of time. On the list were such names as Eastman Kodak, Polaroid, Xerox, IBM, National Student Marketing, International Flavors and Fragrances, RCA, AT & T etc. Many of these firms no longer exist. Even among those who do exist, their stock prices for the most part have not equaled their highs of that era, especially when inflation is factored in.
A similar cycle occurred in the Dot com era of the late 1990s. The profitability of an internet stock at that time was secondary to how fast it was growing. Investors finally became tired of shoveling capital into loss-making enterprises and demanded that companies become profitable. Instead, most of them failed.
It seems that a necessary precondition for financial market manias is an abundance of liquidity, credit, and low interest rates. That has for the most part been the case since 2009 when the Federal Reserve pumped money into the economy to avoid a collapse from real estate values at the time. This was followed by the funds injected to sidestep the effects of Covid. Additional funds were injected to pay for tax cuts that never seemed to create the promised economic growth and tax revenue offset.
Now the Fed is raising interest rates and lenders are tightening credit standards. While many see a relaxation of interest rates and credit terms this fall or early next year, this may be wishful thinking. With a bond portfolio of over $8 Trillion to be redeemed, the Fed has a long way to go to drain liquidity out of the system.
As for the ten stocks that make up 30 percent of the S & P Index*, there is a sense that some may be on borrowed time. To justify the price of Amazon for example (P/E: 80) would require that they transact about 10 percent of the country’s GDP by 2033, up from 1.2 percent now. Nvidia’s per share profits would have to grow fifteen times faster than the overall economy each year for the next ten years to give the stock a current market earnings multiple at the end of that time. Neither is likely to happen.
After the crash of the “Nifty fifty” in 1973-74, the S & P 500 index moved sideways for almost a decade until the next leg up in 1982. People were very angry at stocks, having lost so much money in the market. They piled into limited partnerships, a non-liquid way to invest that can keep you from knowing what you are worth (and how much you have lost) for almost ten years. Ironically, this period was perhaps the best time to buy stocks given their low valuations. He who follows the leader must pay the piper.
* The ten largest stocks in the S & P 500 at this writing are: Apple, Microsoft, Nvidia, Alphabet (Two classes, formerly Google), Meta Platforms (formerly Facebook), Berkshire Hathaway, Tesla, United Health group.
There are many people looking for an economic contraction to justify predicting lower interest rates. So far, they have been looking in vain.
Jobs continue to open at a rapid clip. The ratio of job openings to job seekers hovers between 1.5 and 2.0. The demand for office space and commercial real estate has hit a decline nationwide, but this is at present more a problem for lenders than the investing public.
Efforts to create high-paying jobs are running out because few people are equipped to take them on. The Federal government is spending $52 Billion over the next decade to create a domestic semiconductor chip industry almost from scratch. There are very few places that teach the skills to work in such factories which can pay up to $150,000 per year.
Fed officials describe the current inflation rate as “sticky” which is another way of saying they have no idea as to how to bring it down. The Fed goal of 2 percent inflation per year may be unattainable if the dollar continues to drop against other countries and service wage inflation rages. As import prices are adjusted upwards, domestic producers have a cover to raise prices. Unlike goods, services cannot be automated or pressured by imports. A lack of immigrants means higher wages.
The full effect of monetary tightening has not been felt. The program started early in the year, then was partly reversed when SVB bank collapsed. It is now set to resume.
People who believe the Federal Reserve will not raise interest rates in June forget that there is another meeting and chance in July. While the Fed may “pause” raising interest rates, that is not to say they will stop doing so. They may let the record issuance of treasury paper in the next month do the rate increase for them.
The reason so many people want interest rates to stabilize and then go down is because they are in investments that require lower rates to work. A higher than forecast cost of money can make many investments go from making money to losing the same.
The Stock Market
Since most firms are showing anemic earnings growth this year, and with a slipping hope that interest rates will be cut to support stock valuations, the overall stock market looks vulnerable.
The big issue is whether other sectors of the market will appreciate and help offset the decline in large technology stocks that seem to be accelerating. If so, the overall market will stabilize while the composition of the market index will change. If not, there will be a decline in stock index values as funds are withdrawn to earn 4-5 percent or more in short-term money funds. As of this writing, the public withdrawal from the stock market is proceeding.
Warren M. Barnett, CFA
June 9, 2023
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