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Traders work on the floor of the New York Stock Exchange on April 26. Brendan McDiarmid/Reuters
The leadership of the US stock market is set to expand from the FANG platform (Facebook META-Q, Amazon AMZN-Q, Netflix NFLX-Q, Google GOOGL-Q) and FANG-like technology companies, but the process is complicated by the fact that the craze for artificial intelligence is driving a second-stage rally in some large caps, such as Microsoft MSFT-Q, Alphabet, Meta Platforms, and Nvidia NVDA-Q. To what extent this contributes to a healthy market is one of the most important questions for investors.
By and large, the large tech stocks that have driven U.S. markets since the COVID-19 pandemic began feature secular growth stories that perform best when economic growth is slowing. When stocks that demonstrate significant earnings growth are scarce, as happens during an economic slowdown, investors are willing to pay premium valuations for those that do.
When investors concentrate on the same narrow group of growth stocks, those companies end up dominating the index in terms of market capitalization and performance. Major equity indexes like the S&P 500 and S&P/TSX Composite are market-cap weighted, meaning price movements of the largest companies drive benchmark returns by an order of magnitude more than smaller stocks.
The largest companies also dominate the calculation of the index's average valuation level. As a result, the S&P 500's forward price-to-earnings multiple is now in the 90th percentile compared with its average over the past century, Lisa Shalett, chief investment officer at Morgan Stanley Wealth Management, noted Tuesday.
Valuations are high, and historically this means lower future average returns. The implications of this are of course negative, but two important caveats need to be added at this point. First, as Savita Subramanian, US quantitative strategist at BofA Securities, points out, average valuations are a terrible indicator of short-term returns. Her research shows that valuation levels can account for up to 80% of average annual returns over a 10-year period, but it will take that long. Valuations are not even highly correlated (more precisely, they are inversely correlated) with 8-year returns, let alone what will happen over the next three years.
Another caveat is that current financial accounting may be outdated. Michael Mauboussin, a professor of finance at Columbia University and head of conscientious research at Morgan Stanley, published a landmark paper last month called “Valuation Multiples: What's Missing, Why They're Different, and the Connection to Fundamentals.” In it, he argues that the traditional accounting on which valuation calculations are based was well suited to the manufacturing economy of the 1950s and severely underestimates the attractiveness of today's technology stocks.
The problem of valuing new technologies is reminiscent of Warren Buffett's realization that growth investing would be more successful than the value investing strategy of Depression-era guru Benjamin Graham. This was in part due to Buffett's realization that effective advertising in the relatively new medium of television could create strong brands that could act as competitive moats and help thwart business rivals.
Currently, the U.S. market is still dominated by a relatively small number of stocks, with the top five accounting for 28% of the market capitalization of the S&P 500, making it historically expensive, but average valuation may not be important as a return indicator until around 2030, and may matter very little for technology stocks.
Predicting whether market leadership will shift is almost the same as predicting U.S. and global economic growth. Scotiabank's Hugo Sainte-Marie and Bank of America Securities' Subramanian are two of many strategists who believe the U.S. economy is accelerating in a sustainable way. That means leadership is shifting away from large technology companies with long-term growth prospects to cyclical sectors like industrials and resources, and to smaller caps.
In a scenario where U.S. and global economic growth slows, as predicted by Morgan Stanley U.S. strategist Michael Wilson, investors would likely see even more assets flock to AI stocks, which have the fastest profit growth.
To me, the two most important indicators for gauging these trends are the monthly ISM Manufacturing Purchasing Managers' Index (PMI) survey, which correlates with S&P 500 earnings growth and commodity prices. It has been very weak this year but has improved slightly recently. The second is the Russell 2000 index of US small cap stocks. Small cap outperformance historically signals a new market cycle and market-led expansion. For much of May, the Russell 2000 outperformed the S&P 500, but that trend has reversed over the past week.
