With every passing day and week where one is not invested in the “Magnificent Seven” tech stocks, pressure continues to mount up – at least for those who allow for it. Investors who underperform the broader market indexes, are left in the dark. Usually, active fund managers have to report frequently and to apologize for not having been able to keep pace. It can be a mental strain and cost them their job. Private investors at some point also lose patience and sanity. A plea to stay calm and sane.
Summary and key takeaways from today’s Weekly
– It might seem tough, but now is the time to be smart, not coming late to the party.
– Stock picking is about risks-first.
– Where risks like valuation compressions are too high, one has to stay out consequently.
They say “time in the market is more important than timing the market”.
I’m sure the majority of my readers have heard this phrase more than once. However, I do not necessarily agree, because it depends. For those who invest passively and are happy with their expected long-term market return, this can be a great approach.
Over the last 10–15 years, it worked out pretty satisfactory.
But the other part of the truth is that this also includes longer periods of zero returns. When you had a longer period of above-average returns, logically and mathematically some time in the future, there must follow a period with underperformance. Otherwise, the average market return would be above-average – this is of course not possible and it does not play out.
I am afraid that many, especially younger investors, haven’t understood that properly. Or they know in theory, but are not prepared accordingly.
Will markets crash? In all honesty, I do not think so. Where do you want to go, in government bonds?
Isn’t this contradictory?
No, it is not. My longer-time readers know about sector rotations (see here) and markets moving sideways not just for a couple of years, but more than a decade. I have elaborated on this topic already several times, because it’s so important to understand.
Even if the markets are driving you insane, because you’re having the wrong stocks or are sitting on the sidelines entirely.
So, what to do in times of only rising mega cap and heavy-weight tech stocks?
Is it a rush against time to do nothing?
Not, if you know history and invest based on a risk and reward approach. Most often, risks are seen only in permanent losses due to having picked the wrong stocks. That’s why it is so easy to claim to be investing passively to avoid this particular risk.
What is not seen and discussed that often, but it deserves at least the same attention, are valuation and concentration risks of even otherwise great businesses. Even if one looks like an idiot due to not being invested in those shares, probably missing out on those big gains everyone else is experiencing. Paper gains, otherwise they’d have sold.
In the long-term, stocks follow the underlying business. That’s no secret. Higher profits and cash flows and the stock goes up over time.
However, there are periods in between where despite a growing business the stock does not rise. And it can be really frustrating. The more so, if the former winners switch into above-average losers. Not possible? This time is different?
This is one of the things that’s key for me to communicate not just today, but with my blog as a whole. I want to get this message spread to those who are open minded.
Today, a look back at history and a plea to stay calm and sane.
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About being late to the party
Who likes to show up late to a party when everything is almost over? How’s it like to take the last sip of a close-to emptied champagne bottle, to grab the last crumbs of potato chips or to have a refreshing beer that stood open for hours at room-temperature? If you don’t like beer, imagine something else you enjoy drinking chilled.
Most likely it’s not that fun, even though the event isn’t over, yet. The music is still playing and sentiment is good or even hot, because everyone is drunk and relaxed. Imagine being in that situation.
The likelihood is higher that the best part is behind, not in front of us. Isn’t it?
I am not the first and certainly not the only one to write about this topic. But it is important enough to write another blog post. Should just one reader learn something new and valuable, this will have been worth it.
For reference, my colleague Oliver from the MODERN INVESTING newsletter (with whom I did two cross-interviews, see here and here) dropped a very nice piece recently with some historical parallels worth knowing (see here, but I will also use some of his material below). Also, Kuppy published his thoughts, writing about feeling like we’re in the first quarter of 2000, again (see here).
So far, nothing really has happened and we’ve all been missing out on the Mag7 gains. At least, this is the picture if you only judge by whether one is invested in the hyped tech stocks or not. But being driven by the traditional craftsmanship of a return-, valuations- and risk- / reward-focussed investor makes you feel uncomfortable to join, knowing being late. Likely too late. Even if it isn’t over, yet.
And it has nothing to do with crash prophecy or “seeing” the markets melting away.
It’s just about not taking the risks at too low potential rewards.
Stock-picking is a risks-first strategy. Actually, even investing at all.
At least, if done properly.
Low downside, but decent to high upside.
Imagine you’re looking straight into a slingshot that’s being pulled further and further away from you. There comes a time when it smacks into your face. Better not to be courageous here.
Referring to what I wrote above, being too relaxed when everyone else is, can be dangerous. And painful.
I know that up until here I am writing as if it weren’t me, but this topic is too important for me to pass on it.
Even though I don’t care that much what the big banks publish about stocks, especially price targets, I’ve found two interesting pieces.
The first is from JPMorgan published on Bloomberg. Here’s the quote I saved in preparation for this weekly before they seem to have edited it or at least taken it out of the free preview (slightly shortened by me):
“Some strategists over at JPMorgan are warning that the domination of US equity markets by the 10 biggest stocks is starting to invite comparisons to the dot-com bubble, raising the risk of a selloff. The share of the top ten stocks on the MSCI USA Index (including all of the so-called Magnificent Seven tech stocks) had risen to 29.3% by the end of December. That’s just moderately below the historical peak share of 33.2% back in June 2000.JPMorgan, via Bloomberg, see here
While parallels between the current environment and the speculative frenzy surrounding internet stocks are frequently dismissed, […] the circumstances are far more similar than one may think.”
Comment from me: As the techies have continued to outperform during January, their weight only increased. But just as a side-note.
The other one is via Seeking Alpha about Goldman Sachs saying one of the most common client questions it gets is whether the Magnificent 7 can continue to outperform (see here).
What they did was comparing today’s Mag7 with the Big 5 of 2000 (again, slightly shortened by me):
“Importantly, the Tech Bubble shows that investors believe consensus estimates at their own risk. […] In March 2000, MSFT, CSCO, GE, INTC, and XOM were the largest S&P 500 companies, comprising 18% of the index. Consensus then expected the group would grow sales at a 16% CAGR over the coming two years.Goldman Sachs, via Seeking Alpha (see here)
However, the group fell significantly short, realizing just 8% growth. […] The group went on to underperform the S&P 500 by 21 pp over the next 24 months.”
Please read the last paragraph again and keep it in mind for later.
To sum it up, there’s a huge concentration of just a few popular stocks, having high valuation multiples in general and on average higher than the S&P 500. Also, they are expected to continue to dominate the sphere and to grow into infinity – slightly over-exaggerating things from my side.
There is barely anything new in it, yet, it’s wildly ignored, nonetheless.
Even though the Goldman analyst also correctly said that valuations today are way lower than during the dotcom bubble, it nonetheless is an environment where any grounding seems to have been lost. I know that I’ve been saying and writing to let the winners run. This hasn’t changed. But I am also of the view that one does not marry any stocks and that every trade has its end.
By writing above about risks and not being worth it, the point is that any small deviation from elevated exceptions will lead to disappointments. Disappointments in turn lead to readjustments of expectations and lower valuations as well as stock prices.
Sure, there can be even way higher multiples given, especially due to the ever increasing share of
brain-dead passive investing. Also, those companies can continue to grow their businesses or acquire others to add an inorganic component.
But there are serious and realistic risks to the downside, namely not keeping up with expactations and a deflating of those lofty multiples. Make no mistake, these are all cyclical business, some even highly.
A taste and first impression of what can happen is not even that far behind us.
Does anyone remember 2022 where several of those big tech stocks halved in price temporarily as their cyclical businesses slowed and were confronted with high inflation and uncertainty?
Such circumstances of course do not affect just tech stocks.
But when tech stocks – or any other sector – have priced in a huge success and “nothing can go wrong” is the meme, then you’d better be cautious. My members know that I am currently more tilted towards energy and certain commodities. This won’t stay forever! There will also come a time, when these chapters will be closed.
With this, let’s take a look at history.
Oliver from the MODERN INVESTING newsletter cited a comprehensive analysis with the name “Party like it’s 1972: What Can the Nifty Fifty Teach Us About Todays Market?” Even though this piece from Bridgeway Capital Management is from somewhere before 2022, i.e. before the above-shown brutal correction, the content is as valid and up to date as ever. You can find the whole analysis here.
If you have five minutes, please read it.
It already starts with a strong introduction that the authors continue to comment on later with historical figures and developments:
Hot stocks, even if resulting from strong financial performance, do not guarantee investing success if their prices have been bid up too high.
Bridgeway Capital Management (see here)
This sentence is something every serious investor should have burnt into his mind.
And don’t get me wrong. I am by no means just referring to unprofitable companies that tell you great stories. This applies to every stock.
The authors also rather compare today’s tech darlings not with the dotcom bubble, but with the infamous Nifty 50 stocks of the late-1960s to mid-1970s. As a short reminder, this was bunch of then high-quality stocks with strong and leading businesses, growth, but also rich valuations. In fact, even richer than today.
However, there are two commonalities: “nothing could go wrong” and they all were / are above-average. If one wasn’t invested then into those stocks, one obviously was an ignorant idiot for missing out on safe gains. Where else to be invested if not in the leading and highest-quality companies?
It’s the same today.
A great business is not automatically a good stock (and vice versa). It depends on the price – sooner or later.
But what happened? Here is a screenshot from a core part of their writing.
Don’t tell me that it does not read like today – just leave out the years.
Whether history repeats or rhymes, is debatable. But what is not is that human nature does not change. Only the protagonists and scenes do.
So, what goes up strongly, has a fairly good chance of coming back strongly, too.
Chances are (or the risk is) higher, when valuations are so rich that success is a given. It never is. It is also part of the truth that several companies of those days like Polaroid, Kodak or Sears simply do not exist today, anymore. I wouldn’t be so sure that all of today’s leaders will still exist in the future.
The only constant is change, as they say.
Anyway, there comes a time when great or above-average results won’t be enough. It will already be expected and priced into those stocks. Everyone knows sayings like “sell the news” or “that was expected, where is the surprise to the upside?”.
Just to give you an example, let’s look at Apple (ISIN: US0378331005, Ticker: AAPL).
Apple has a current forward PE ratio (for simplicity reasons) of around 28–29x. This definitely includes a growth premium. Companies without growth that are finished don’t trade for almost 30x multiples. I don’t know whether Apple is finished. But what I know, Apple has been struggling as of late to grow. And whether it’s 0% or 5% growth – both rates are certainly too low to justify a high-growth multiple of around 30x.
So assuming a more healthy multiple of 20x and a current share price of 190 USD for a high-quality, but low-growth business – not to mention that we have higher interest rates and Apple seems to have serious issues in China – Apple would need to increase its current earnings per share from 6.42 USD (trailing 12 months) to 9.50 USD or by 39% – only to keep the same share price under a 20x multiple.
Which by the way still includes a small growth premium.
Is Apple able to hike its earnings per share by 39% over the foreseeable future? Buybacks only contribute about 3% p.a. It’s possible, sure.
But you certainly would invest in Apple to increase your money, not to keep it stable. So, to double your money over the next 7 years (around 10% p.a.), but taking into consideration that Apple’s valuation multiple could decrease from 30x to 20x, Apple would need to increase its earnings per share from 6.42 USD to even 19 USD – or tripple it (stock of 380 USD / 20x multiple).
Will that happen? It can, but this is a tough and risky bet.
You can apply this principle to all of the other big tech stocks, too. It will be even more interesting there, as it all assumes that no competition will come up and nothing disturbing happens. However, we also know that no trend evolves just from the bottom left to the upper right in a straight line.
There are – at times painful – ups and downs along the way.
In the end, you do not want to be the victim, but the defensive contrarian who avoids losing sanity. Growth is nice, but when it does not come in as expected, things can turn really sour and ugly. No stock – not a single one – is immune to falling.
It is more likely that the big money has already been made with the Mag7.
One of the hardest things in invest is to stomach valuation compression, because it may not only crush your returns, but also your confidence.
Even though the underlying business is doing well.
The “California Dreaming” song about the tech stocks can and likely for some time will continue to play. But this could be the last song of the party. Keep this in mind.
And as a reminder, even though I’ve shown this chart already a few times, it cannot be shown often enough. There are always times when the broader markets do nothing. Not just for a few years during a small correction. There have been and likely again will be times where for more than a decade nothing happens except a narrow trading range, assuming no serious crash emerges:
Or as Charlie Munger said:
People are trying to be smart – all I am trying to do is not to be stupid, but it’s harder than most people think.Charlie Munger
Indeed, it is really hard to say “no”, where others are greedy. And the more so, if they are right and you are sitting there as an outsider.
Serious investing is “risk first”. Always ask yourself: “What could go wrong?”
There are no certainties, only probabilities.
When the latter is not in your favor, better pass on it.
Even though probably pretty boring compared to the tech party, my latest research report for my members was about an energy company. Its biggest earnings driver is usually oil, but it has a big and not to be underestimated gas business, too.
Even assuming lower cash flows, the valuation multiple is simply way too low. As a bonus, the balance sheet ist flush with net liquidity that the management wants to get rid of over time. It just announced again big shareholder distributions to reduce the huge net cash position. A dividend of 10% plus above-average buybacks compared to the peer group make for a compelling case.
It might seem tough, but now is the time to be smart, not coming late to the party.
Stock picking is about risks-first.
Where risks like valuation compressions are too high, one has to stay out consequently.
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