Traders work on the floor at the New York Stock Exchange in New York City on April 26.Brendan McDermid/Reuters
Leadership in U.S. stock markets ls trying to broaden out from the FANG platforms (Facebook META-Q, Amazon AMZN-Q, Netflix NFLX-Q and Google GOOGL-Q) and FANG-adjacent technology companies, but the process is complicated by the fact that hype over artificial intelligence is giving select large-cap stocks – notably Microsoft MSFT-Q, Alphabet, Meta Platforms and Nvidia NVDA-Q – a second leg higher. The degree to which this is conducive to a healthy market is one of the most important issues for investors.
Broadly speaking, the megacap tech stocks that have led U.S. markets since the COVID-19 pandemic began are characterized by secular growth stories that outperform most when economic expansion is slow. When there are fewer stocks with significant profit growth, as happens during economic slowdowns, investors are willing to pay high valuations for those that show it.
Investors piling into the same narrow group of growth stocks leads to those companies dominating the index in terms of market capitalization and performance. Primary equity indexes such as the S&P 500 and the S&P/TSX Composite are market-cap-weighted, meaning price movements in the biggest companies drive benchmark returns by orders of magnitude more than those of smaller stocks.
The largest companies also dominate the calculation of average valuation levels for an index. Lisa Shalett, chief investment officer at Morgan Stanley Wealth Management, noted Tuesday that the result is that the S&P 500′s forward price-to-earnings ratio is now high enough to hit the 90th percentile relative to the average of the past century.
Valuations are high and historically this has meant lower average future returns. The implications of this are of course negative, but we need to insert two important caveats at this point. One, as BofA Securities U.S. quantitative strategist Savita Subramanian observes, average valuations are a terrible indicator of short-term returns. Valuation levels can account for up to 80 per cent of 10-year average annual returns, according to her work, but it takes all of that time – valuations are not very correlated (or, more accurately, inversely correlated) with even eight-year returns, never mind what happens over the next three.
The other caveat is that current financial accounting may be outdated. Michael Mauboussin, Columbia University finance professor and head of Consilient Research at Morgan Stanley, published an important paper last month called ”Valuation Multiples: What They Miss, Why They Differ, and the Link to Fundamentals”. In it, he argues that the conventional accounting that underpins valuation calculations is much better suited to the manufacturing economies of the 1950s and vastly understates the attractiveness of technology stocks now.
The question of valuing new technology is reminiscent of Warren Buffett’s realization that growth investing would succeed better than the Depression-era value investing strategies of his mentor, Benjamin Graham. This was in part due to Mr. Buffett’s realization that effective advertising on the new-ish medium of television could help create powerful brands that would act as a competitive moat that would help thwart business rivals.
The U.S. market as it stands is still dominated by a relatively few stocks – the five largest stocks account for 28 per cent of total market cap of the S&P 500 – and is expensive relative to history. But the average valuations may not matter as an indicator of returns until 2030 or so and, where technology stocks are concerned, may barely matter at all.
To predict whether market leadership will change is almost the same thing as forecasting U.S. and broader global economic growth. Scotiabank’s Hugo Ste-Marie and Ms. Subramanian from BofA Securities are just two of many strategists who believe the U.S. economy is accelerating in a sustainable way. That implies a change in leadership from large-cap secular growth technology companies to more economically sensitive sectors such as industrials and resources, and smaller capitalization stocks.
A scenario in which U.S. and global economic growth slows, as Morgan Stanley U.S. strategist Michael Wilson forecasts, would likely see even more investor assets gravitating to AI-related stocks that are showing the most intense profit growth.
Two indicators are most important for me in gauging these trends. The monthly ISM Purchasing Manager Index (PMI) for Manufacturers survey is correlated with S&P 500 earnings growth and commodity prices. It’s been very weak this year, but slightly improving lately. The second is the Russell 2000 Index of U.S. small caps. Smaller cap outperformance has historically indicated a new market cycle and a broadening of market leadership. In much of May, the Russell 2000 outperformed the S&P 500, although that trend has reversed over the past week.