Why The Stock Market Is Poised To Disappoint For A Decade Or Longer
Perhaps it is due to the innovation cycle, but companies seem to emerge every two-to-three decades that are so powerful, and their business models so unassailable, it becomes nearly impossible to image a world in which they could be challenged successfully. Growth prospects virtually assured, investors come to believe their dominance is permanent; and their stocks increasingly become seen as “no-brainer” investments.
No-brainers are necessarily large corporations, mega-caps really, because it takes years and years of success for a company to build a formidable reputation. No-brainers are always the “top dogs” in a massive addressable market.
Half a century ago, the no-brainers of the time were called, Nifty-fifty stocks. These were big and solidly profitable blue-chip companies holding sway over fast-growing, ever expanding markets. They included great companies like Coca-Cola KO , Disney and 3M MMM and outperformed every Index for several years, starting in the late 1960s. When the severe bear market of 1973 showed its ugly head, Nifty-fifty stocks initially held up well for many months, “proving” their resilience, as the financial press observed at the time.
About two decades ago, a new crop of no-brainers emerged. As the Internet was becoming ubiquitous, no-brainers included large, quality companies in technology, media, and telecoms, the so-called TMT stocks. Some of the great growth companies from that era include Cisco CSCO Systems, Intel Corporation INTC and Qualcomm QCOM .
I give two examples of the past half century, but the phenomenon is as old as investing. The South Seas Bubble of the 1710s is an early example. Sir Isaac Newton, the greatest of mathematicians, famously fell prey to no-brainer thinking and consequently nearly lost all his money. When Benjamin Graham warned investors in the 1940s that “obvious prospects for growth in a business do not translate into obvious profits for investors,” he was referring to no-brainers.
We are once again in an Age of no-brainers and today’s crop include some of the most valuable companies the world has ever seen. You need to go back to the Robber Barron era of the 19th Century to find so few companies potentially dominating the economy in a way the six biggest no-brainers in the S&P 500, Facebook, Amazon AMZN , Netflix NFLX , Microsoft MSFT , Apple AAPL and Google (called FANMAGs), currently appear to dominate today’s digital economy.
If there is any doubt the future does not belong to these great companies, it is not expressed in their valuations. Bullish sentiment has propelled their stocks to record peaks and are up a third from the pre-pandemic highs reached in February. Selling at 60X earnings, today’s crop of no-brainers now rival levels reached by the no-brainers of both the TMT and Nifty-fifty eras. (Source: Bespoke Investments.)
The practical effect of mega-capitalization companies selling at such high multiples of earnings means a handful of companies have, and will continue to have, an outsized effect on the stock market. It is truly unprecedented. At the end of August, the top 6 no-brainers comprised 24% of the S&P 500 Index and the top 5 no-brainers in the Russell 1000 Index accounted for 37% of that portfolio’s value.
This has given a distorted view of the seeming divide between the performance of Wall Street and Main Street this year. Yes, the stock market is up for the year but, apart from no-brainers, stocks are having a rough year and their performance more closely mirrors Main Street.
In the S&P 500, over a hundred companies remain 50% or more below their highs, while the average stock remains 28.4% below their peaks, according to Cornerstone Macro Research. Mid-cap value stocks are down -15% year-to-date and small caps are off -18%, for instance.
A recent Goldman Sachs GS thought experiment addresses the simple math of what this concentration means in practice. Assume the top 5 companies in the S&P 500 Index decline by 10%, and the next 395 largest companies trade flat. To keep the Index from falling in this example, the bottom 100 companies in the Index would need to nearly double.
Bottom line: owning the American stock market today through diversified Indexes represents a concentrated bet on no-brainers. Given the popularity of Indexing with its promise of diversification, it is ironic the security of people’s retirement may hinge on the success or failure of a handful of stocks.
So, what can History teach us about no-brainer stocks?
First, there is always a mathematical case to be made for owning no-brainers. Simply put, the current earnings yield of the FANMAGs as a group is 1.6%, but their projected yield, due to growing profits, is 2.4%. This compares to an earnings yield of 5% for the rest of the S&P 500 companies.
An initial earnings yield of 2.4% may not seem attractive, but the market’s embedded growth assumption is for FANMAG earnings to increase by 15% to 18% a year. That means the market believes the FANMAG yield will double twice over the next 8 – 10 years.
Think of this as meaning the “cost-basis yield” on these no-brainers, will grow from a paltry 2.4% to more like 10% in less than a decade. By comparison, the projected earnings yield on the rest of the S&P 500 in a decade is 8.14%, assuming trend line growth of 5% a year.
There is a narrative these no-brainers are uniquely safe, given their superior business models, scale, and growth prospects. The predictability of their cash flows is seen as not dissimilar to bonds in some circles, except better because they will increase.
So, if you are a pension plan manager, for instance, and by necessity take a long view, FANMAGs might be an attractive bet in comparison to the 0.68% on offer from 10-year Government bonds. Remember, the paltry yield on the bond is fixed.
Second, no-brainers tend to have a melt-up phase due to strong narratives regarding their virtues and these stories feed on themselves. As stocks reach bubbly levels of optimism, many investors who failed to participate in the no-brainer bull market develop FOMO, the fear-of-missing-out, and this sets the table for a final stampede of buying.
Tesla TSLA is not a FANMAG, and perhaps it is not a no-brainer as many skeptics remain, but it is a bubble stock and is illustrative of the power of narratives. Tesla used to be seen mostly as an electric car company with some first-mover advantages, but a new narrative has emerged. In justifying its 10X share price increase since last year, Tesla is now touted as the “category-killer” in the transformation of human mobility.
Third, when the tide turns, and no-brainers share prices fall, it is simply due to reduced optimism regarding their growth prospects. They may continue to grow at a fast clip for years, but if projections about growth rates are reduced, disappointing returns both for the no-brainers themselves, and “the stock market” itself as no-brainers drag the Indexes down with them, will follow.
Back to the three TMT-era companies mentioned above. Two decades after making a new high in its stock, Qualcomm shareholders were finally “made whole” in the past year, but long-term Cisco and Intel shareholders remain in the red.
Regarding “the stock market,” it took nearly a decade for the S&P 500 to reach its Nifty-fifty levels again, and 13 years to recover from the TMT-bubble. Given the concentration of no-brainers in the S&P 500 today, this time could be longer.
The primary reason why no-brainers disappoint investors is capitalism. Bruce Greenwald uses the metaphor of a mythical no-brainer company called Top Toaster.
Top Toaster’s growth rate, and its high returns on capital, gradually drop as competitors seek to join the party. This will drive incremental returns lower, towards its cost of capital, thereby dragging its P/E multiple ever lower. This is the future of nearly all companies says Greenwald, a professor at Columbia University, because “in the long run, everything is a toaster.”
It is important to understand the implications of a lower P/E multiple. Currently, the FAANGs are priced as if their earnings will grow 15% perpetually.
What if that assumption changes tomorrow and the market’s growth assumption drops to a still fantastic 12%? Answer: the mathematics imply the stocks will drop by 26%.
What if the growth assumption then drops to 10%? Answer: the stocks will fall by another 18%.
So, a stock trading at $100 will fall to about $60 based on investor growth assumptions falling from 15% a year to 10% a year. Putting things into context, the average large US company will grow earnings by 5%, if history is our guide.
If our mythical no-brainer is currently $100 and investors eventually settle on a still respectable 7% growth assumption, the share price will fall another 23% to something like $47. (Please go to NYU Professor Damodaran’s website if you want detailed analysis on P/Es and growth assumptions.)
The key is this: expanding growth assumptions, and low interest rates, have led to the meteoric rise in the share prices of today’s no-brainers. Embedded in Apple’s shares was a 7 – 8% growth assumption as recently as last year. It looks as if their earnings will indeed increase by that amount this year. So, how to account for the 3X increase in Apple’s share price over the last many months? Sentiment has changed. It is the multiplier effect of increasing growth assumptions that has led to the terrific performance. Apple is now seen as a 12 – 15% grower.
Expanding growth assumptions have had a multiplier effect on the way up. It will have a multiplier effect on the way down, once growth assumptions are challenged by market participants, as the P/E examples above demonstrate.
If my argument fails to convince you of the high-risk-in-plain-sight posed by owning no-brainers specifically, and the negative implications for the “stock market” in general, try some common sense.
The FANMAGs are worth some $7.2 Trillion, or roughly a quarter of the value of the other 494 components of the S&P 500 combined. If their embedded growth assumption is correct, FANMAGs will be worth nearly $120 Trillion in 20 years while the rest of the S&P 500 combined will be worth about $60 Trillion, assuming an optimistic 5% growth rate.
In other words, if the six FANMAGs are properly valued today, they will be worth twice as much as the other 494 companies combined in two decades.
Now, Warren Buffett has said the percentage of total market cap relative to the US GNP is “probably the best single measure of where valuations stand at any given moment.” At the height of the TMT bubble, the ratio got to a record high level of 1.4X, implying an overvalued stock market. In the Great Recession of 2008-09 the ratio stood as low as .56X, implying significant undervaluation. It is now 1.8X, implying significant overvaluation.
If the economy grows by 3% a year over the next two decades, a reasonably optimistic assumption, GNP will still only be $40 Trillion in 20-years. I believe it defies belief that six companies could not only be worth twice the value of the next largest 494 companies in the S&P 500, but also trade at 3X GNP.
I believe it is not a question of if no-brainers will serve as a long term drag on stock market performance. It is simply a matter of when, and we may well be on the cusp.