Intel's Out, NVIDIA's In: Most Sentiment-Induced Dow 30 Index Change Ever?

Long-time readers of this blog know that I am always interested when the owners of the Dow Jones Industrial Average (DJIA) announce a change to one or more of the index’s 30 components (do a search for “Dow” on this site to see past articles). Usually it is a very good lesson in sentiment-based investing and happens at a time that will only hurt the index’s future performance (take out the losers and replace them with high-flyers). The latest change announced late last week might take the cake though. Intel (INTC) is out after 25 years and is being replaced by Nvidia (NVDA).

Intel was added to the Dow on November 1, 1999, just months before the tech bubble peaked in March 2000, which is yet another data point supporting the idea that Dow changes can serve as strong contrarian indicators (changes to large indices are mostly based on market cap, whereas since the Dow only has 30 companies, it’s basically a handful of people making a discretionary call on their own).

So where was Intel trading when it was added in late 1999 versus where it is today? On a split-adjusted basis INTC shares closed at $21.99 each the day before being added to the Dow. Now 25 years later, INTC closed at $21.52 just before the change was announced. Sure, there were some dividend payments made to shareholders along the way, but that just means the stock has compounded at barely above zero precent a year for nearly three decades since being added to the Dow.

As if there weren’t enough buyer beware signals for NVIDIA stock already (e.g. massive stock sales by the CEO constantly), this is yet another sign of extreme public sentiment. Much of it may very well be deserved… the question is simply whether all of it is.

U.S. Stock Market Value Concentration Now Narrowest On Record

Do you remember the first time a U.S. listed company reached a market value of $1 trillion? If it doesn’t seem like that milestone was achieved that long ago, that’s because it’s only been six years (Apple, in the summer of 2018). The tech giant at that point comprised about 4% of the S&P 500 index’s total value. A nice chunk for sure, but hardly astonishing or potentially problematic.

Fast forward to mid-2024 and the value concentration has gotten far more narrow. We now have three companies (Apple, along with Microsoft and NVIDIA) that carry market values of more than $3 trillion each. The trio together comprise more than 20% of the S&P 500 index’s market value. Think about that… 0.6% of the stocks comprise more than 20% of the value. It truly is the most concentrated market we’ve ever seen.

Market technicians often monitor overall breadth closely to try and gauge general market conditions, but since I am a more fundamental investor I don’t have much in the way of statistics to share on that front. What I have noticed, though, is that the bulk of the U.S. stock market has stagnated.

Consider the Russell 3000 index (which comprises about 90% of all major exchange listed U.S. stocks) and its offshoots; the Russell 2000 (smallest 2,000) and Russell 1000 (largest 1,000). As of yesterday’s close, on a year-to-date basis, the Russell 2000 was unchanged for the year, whereas the Russell 1000 was up 14%. If we distinguish between the market-cap weighted S&P 500 index and the equal-weighted version, we see a similar pattern (cap-weighted up 15%, equal-weighted up 5%.

Narrow breadth in and of itself, while not a great sign, doesn’t concern me too much. The bigger issue I see is the euphoria surrounding a very narrow group of stocks. When my golfing buddies and young relatives (neither having showed any interest in the market before) are all talking about buying NVIDIA, all it does is remind me of other moments of maximum stock market bullishness… and how they rarely last.

Big Tech Valuations Are Greatly Skewing the S&P 500's Overall Valuation

With the benchmark 10-year government bond rate now yielding around 5% it can be a bit disheartening for equity investors to see the S&P 500 fetching about 19 times earnings. At best, future upside in price is likely going to need to come from profit growth, not multiple expansion. And if a recession materializes in 2024, prompting a material decline in multiples, well, look out below.

That’s the bad news.

The good news is that the big tech sector has grown to be such a large portion of the overall market that non-tech stocks actually aren’t richly priced at all, even in the current interest rate environment.

Consider the 7 largest tech stocks in the market - Apple, Microsoft, Amazon, Alphabet, Nvidia, Tesla, and Meta Platforms. Together they comprise 28% of the market cap weighted S&P 500 and sport a blended P/E ratio of 37x. Some simple algebra tells us that the rest of the market (the remaining 72%) carries a blended P/E ratio of just 12x. That latter figure makes sense considering stocks generally are well off of their all-time highs and rate increases have clearly been a headwind over the last 24 months or so.

The analysis remains consistent if we expand the calculation to include more of the tech sector. Information technology alone (excluding communications services - which is a separate S&P sector designation) comprises about 27% of the cap-weighted S&P 500 and sports a 29x P/E ratio. Doing the same number crunching shows that the remaining 10 sectors of the index combined carry a P/E ratio of just 16x.

If we try to determine what “fair value” is for the U.S. equity market given the 5% 10-year bond rate, most market pundits would probably say somewhere in the “mid teens” (on a P/E basis) based on historical data. In that scenario, 19x for the entire S&P 500 seems high, until we consider that tech stocks account for the elevated level overall. Exclude tech and (depending on your preferred methodology) everything else trades for a low to mid double-digit earnings multiple - which certainly makes it easier to sleep at night. It also likely explains why there are no shortage of attractively priced stocks outside of the high flying tech names that most people focus on. That’s probably the best place to focus right now as a result.

How Well Will Earnings Hold Up? Watch The Job Market...

With corporate profits set to fall for calendar year 2022 (final results won’t be known for weeks), the big question for equity investors is whether 2023 will bring stability on that front or not. Wall Street strategists largely expect another decline as economic headwinds accumulate, but the sell side is staying rosy (current consensus forecast is earnings growth of ~10%) and likely will continue that stance until companies explicitly give them 2023 guidance because they have very little reason to go out on a limb and make their own forecasts.

The economic and investment climate today reminds me a lot of 2015-2016. Back then earnings also showed a year-over-year decline (2015) during a time when overall economic indicators remained bright. The U.S. unemployment rate fell that year, and GDP growth actually accelerated. The biggest culprit for profits was energy prices, which fell dramatically and sparked a wave of financial distress for much of that sector and the lenders who funded their operations. Fortunately, the energy bear market eventually resolved itself through normal supply and demand rebalancing and overall U.S. corporate earnings rose in 2016 and set a new record in 2017. The result was only a single down year for the U.S. stock market.

From my vantage point, tech is the new energy in this comparison. The pandemic brought forward a ton of growth for digital businesses and now that pent-up demand is waning, growth has slowed materially (going negative for many companies) and layoffs are mounting. But as was the case back in 2015, the rest of the economy is pulling its weight just fine. There are labor shortages in many areas, which has resulted in the U.S. unemployment rate actually dropping over the last 12 months (4.0% to 3.4%) despite the Federal Reserve raising the Fed Funds interest rate by a stunning 450 basis points during that time.

You can tell the stock market isn’t really sure what to make of all this. After a sharp drop in 2022, this year has started with a bang as earnings are holding up so far and GDP growth remains in the black with more jobs created every month. The thesis that corporate profits fall in 2023 may still play out, but the timetable on which that becomes obvious keeps getting pushed out, which means stock prices can start to discount the possibility that such a scenario doesn’t materialize (what we are seeing this week).

I think watching the job market is the key. What if we can get through a full rate hiking cycle with the unemployment rate staying below, say, 5%, and most of the firings come from big tech companies? Could most of those workers find new jobs with “smaller and older” tech businesses who previously couldn’t compete with posh offers from the likes of Google and Facebook? If so, we might just see a soft landing after all. With the consumer always the main driver of the U.S. economy, they will tell the story this cycle as well. Without strong incomes, the negative impact on the bottom lines for lenders and sectors like hospitality, retail, and entertainment becomes a downhill wipeout.

Where do I think we wind up? Hard to say, but I definitely think the current 2023 earnings forecast of $223 (versus $200-$205 for 2022) is overly optimistic. If we can’t push much past $200 with the current backdrop today’s S&P 500 quote of 4,100+ appears quite rich with a 3.5% 10-year bond yield. For the bullish scenario to play out we would probably need to see growth in 2023 (say, $210+) with a clear path towards an acceleration in 2024 to $230+ (after all, 18 times $230 equates to 4,140 on the S&P 500). Buckle your seatbelts… if January was any indication the range of outcomes is quite wide.

Now Available: Bear Market Blue Chip Bargains

One of the best things about bear markets in stocks is that investors can get pretty good prices for blue chip stocks that trade at material premiums during most of the business cycle. As the market declines we can find more and more examples. Here is one I took a screenshot of a few days ago. Cut in half year-to-date, for a company of this caliber? Wow, despite it being quite overvalued near its peak. Looking back five or ten years from now, how will it look if we put some shares away for the long haul today? Feels like an interesting add to a youngster’s college fund, for instance.

Starbucks Buyback Plan Highlights Why Opportunistic Corporate Buying Is Rare

There are a lot of mixed feelings about corporate stock buybacks depending on which group of stakeholders one polls, but one thing is clear; finding instances when management teams choose to buy mostly when their stocks are temporarily and unfairly depressed is a difficult task. When times are good (and share prices reflect this sentiment), buybacks seem like an easy capital allocation decision for ever-optimistic CEOs and CFOs. When the tide turns cash is conserved and debt repayment takes precedent even as the stock price tanks to attractive levels.

Coffee giant Starbucks (SBUX) is the latest example. With union pressure coming at them in full force, the company suspended buybacks in early April so they could improve operations and employee morale without taking a political hit from returning more cash to shareholders. This week they announced they will resume buybacks in about a year, after their turnaround plan is largely completed. You can probably guess what happened to the stock price during the last five months:

See that wonderful chance for the company to retire shares in the 70’s while sentiment about their relations with employees was at its absolute worst? Yeah, sorry everyone, buybacks were suspended. Yikes.

So if we can’t rely on management to repurchase shares at the best prices, should we swear off the notion that buybacks are shareholder-friendly? A lot of people take that view, but I don’t think it’s entirely fair. Buybacks remain a way to return capital to investors in a tax-efficient manner. Dividend payments force investors to sell a portion of their investment and often results in a tax liability. If you own stock it is safe to assume you want to keep it so forcing a partial sale every three months is not ideal. If you want to sell some, you can do so on your own, and in today’s world for zero commission.

As an investor, it is probably best to think of stock buybacks as equivalent to a tax-free dividend reinvestment program. Your capital stays invested and taxes are avoided, which leaves you and you alone to determine the timing and magnitude of any position trimming. The dividend analogy also rings true because just as dividend payments are executed every quarter no matter the price of the stock, so too are most buyback programs (unfortunately).

All in all, buybacks are probably here to stay even with the new 1% federal tax that begins next year. While I prefer them to dividends (for growth companies especially), it is still pretty annoying when companies don’t match their buyback patterns with the underlying stock price volatility. When a cash cow business like Starbucks adopts the same shortcomings, it’s a good reminder that they are the rule more than the exception.

Full Disclosure: Long shares of SBUX at the time of writing but positions may change at any time

Unlike with GameStop, Ryan Cohen Cashes In His Chips Just In The Nick Of Time

“Why on earth would I pay an advisor when I can trade for free with Robinhood on my phone?”

- 27 year-old meme stock trader

I am asked about meme stocks and my opinion of people like Ryan Cohen all the time. Cohen was interesting because while he has amassed a fortune over the last decade (all due credit to him), each move had also resulted in him leaving a lot on the table. He hasn’t really had a Mark Cuban moment yet (Cuban sold Broadcast.com at the top for all stock and immediately hedged the Yahoo shares he received before they crashed) so his loyal cult-like following is interesting. Consider that:

Cohen sold Chewy in 2017 for $3 billion in cash, but the buyer (PetSmart) took it public in 2019 at a value of $9 billion and today it’s worth $18 billion. About $15 billion left on the table at current prices.

Cohen bought 5.8 million shares of GameStop in August of 2020 for a mere $6 apiece (pre-split). But when they skyrocketed more than 80-fold in just five months (peaking at a stunning $483 apiece) he didn’t sell or hedge a single share. About $2 billion left on the table at current prices.

His Bed Bath and Beyond common stock investment appeared on its way to the gutter. The purchase of nearly 8 million shares at ~$15 apiece during Q1 2022 had lost 2/3 of its value as of 3 weeks ago and his proclamation that the chain’s buybuy Baby unit was worth more than $15 per share by itself was proven to be totally off the mark after buyout offers came in nowhere near that price.

Perhaps Mr. Cohen has learned a lot. When his followers bid up BBBY stock to $30 from $5 in just 12 trading days this month, Cohen unloaded quickly, selling it all in just 2 days and netting a profit of nearly $70 million or 56% while his Twitter followers were claiming he wasn’t going to sell. This trade was timed perfectly, though his business valuation skills aren’t yet in the same league as other prominent activist investors.

The move reminded me of Silver Lake Partners’ stake in the convertible debt of AMC back in 2021. Cohen’s followers hate the “smart money” hedge funds and private equity funds, but Silver Lake did what they all try to do; play the hand you are dealt the best you can. Silver Lake was sitting on losing hand of underwater AMC convertible debt in a company that nearly went bankrupt during the pandemic, but the meme stock folks bailed them out. By bidding up shares of AMC, it allowed Silver Lake to convert their debt into equity and on the very same day sell every single share at a profit.

It turns out Ryan Cohen lacks “diamond hands” when it becomes obvious that is the right move. I don’t know if people will turn on Cohen after this BBBY experiment (as with GameStop, most of them will show big losses after following him blindly), but I do know that we should not be cheering amateur investors who are gambling on these stocks without understanding valuations, balance sheets, or SEC filings. It was obvious to professionals that Cohen’s amended 13D from August 16th showed no new positions in BBBY. The filing itself even said so: “This Amendment No. 2 was triggered solely due to a change in the number of outstanding Shares of the Issuer.” But most people didn’t actually read it. Instead they just relied on posts on Twitter and Reddit to get bullish and pile in. And the ensuing rally gave Cohen his selling opportunity.

Even after Cohen filed to sell his entire stake and the filing was made public on August 17th, the believers were saying he hadn’t yet sold, even though the filing itself said he expected to sell on the 16th. And what do you know? By the close of trading on the 17th he was out completely after 2 days of selling.

These are easy things for an investment advisor to understand and offer guidance on. There were other silly rumors too, being spread by novices, like the one that said since he hadn’t held his stock for 6 months every dollar of profit Cohen made would have to be returned to BBBY, which would help them repay their debt. Sure.

Look, I am not saying that everyone needs to hire an advisor and be completely hands off with their investment portfolio. But having a pro to bounce ideas off of and direct questions to can literally pay for itself in a single trade if one is inexperienced and making speculative bets without understanding what is really going on. It can be a collaborative business relationship that adds value. And over the long term, many novices will become knowledgeable enough through experience that they can rely less and less on their advisor and eventually jettison them completely if they prefer.

The investing environment today reminds me a lot of 2000-2002 when I started in this business as an advisor. People had gotten burned by the tech stock bubble and were swearing off investing completely (not completely clear if the Robinhood crowd will get to this point yet - but their trading volumes suggest probably). They sold their Invesco tech mutual fund and put what was left in bank CDs. Those kinds of moves almost never work out well, but after you’ve been burned it’s hard to venture back into the kitchen.

I am afraid that the same thing is going to happen with the new young generation of investors. First, it was about screwing over the large hedge funds and leveling the playing field for the little guy and gal. But the field is not level when we are dealing with understanding the markets. It’s fine to hate Citadel but blindly following people on Twitter and Reddit is not going to help you build wealth. If people like Ryan Cohen start acting like the same Wall Street activist hedge funds that they love to hate, it will likely turn off this new generation from the markets.

Could Corporate Profits Hold Up Better This Cycle?

If the pandemic has taught us anything I think it is that this economic cycle is unlike any others we can point to in history given the uniqueness of how the entire globe has had to react to Covid-19. The investment community tends to try and predict current trajectories with those of prior cycles, and I am no different. In fact, in my latest quarterly letter to clients I pointed out that during the last four recessions S&P companies saw profits fall between 20% and 40% peak to trough. Coupled with near-certain multiple compression, it is easy to see how and why stock prices get walloped during recessionary periods, even if the drops are relatively short-lived in the grand scheme of things.

So here is where I am going to through a wrinkle into the discussion. What if things play out a little bit different this time? I doubt we can avoid a recession at this point, given that Q1 GDP was negative (due solely to a lack of exports by the way - entirely pandemic related). Q2 GDP could easily put us into a recession. In fact, the Atlanta Fed’s real time estimate for Q2 is currently showing a negative reading, so that ship might have sailed already. So what would be different this time? Well, what if corporate profits hold up better than in recent prior cycles, which could serve to cushion the downturn in stock prices a bit and help spring a fairly quick recovery?

There are a few factors that I think could play into this thesis. First, Q1 earnings actually rose year over year despite negative GDP growth. Current forecasts call for another (small) increase for Q2 despite a possible negative GDP print. So that’s interesting. Even if second half 2022 profits fall versus 2021, it would take quite a big impact to see the typical 20-40% decline from 2021’s record profit level.

There are multiple tailwinds to earnings this cycle that have not been big factors in recent decades. Strong energy prices relative to what we would normally see in a recession? Check. High inflation that keeps revenue figures elevated as long as customers don’t balk at buying? Check. Interest rates that are rising rather than falling, which would actually help the bottom lines of many financial companies? Check. A historically tight labor market that might result in the unemployment rate rising less during this downturn that prior ones? Check. Relatively limited supply of housing units relative to demand that could limit any glut/price collapse for both owned and rented properties? Check.

Look, this is just a thesis that seems like it has a bunch of bullet points going for it. I have no idea if we actually see corporate profits only decline 10 or 15% this cycle versus 20-40% historically. But if one is feeling a tad more bullish than many headlines would indicate, there are green shoots to point to.

I also wonder if this is why the P/E for the U.S. stock market remains near historical averages for a mid-cycle climate (16-17x) rather than a recession (10-14x). If a recession comes but profits hang in there, there might not be a reason for stocks to ever trade that low. So maybe the market is expecting profits to hold up rather well, just as I am postulating. Of course, the flip side of the argument is not reassuring (i.e. if this thesis is wrong maybe another big leg down is coming).

Needless to say, I am more interested in watching profit numbers than I am GDP or CPI going forward. While I agree estimates need to come down from current levels, I want to see by how much. I think that will tell us whether the worst for the market is behind us, or if 2022-2023 is going to play out similarly to 2001/2008/2020.

For those who will be doing the same, here is where the numbers stand as of today for S&P profits:

2021 CY: $208 (all-time record, 32% above 2019’s $157)

TTM Q1: $210 (+40% yoy)

2022 Q1: $49 (+4% yoy)

2022 Q2: $55 (estimate, +5% yoy)

2022 CY: $223 (estimate, +7% yoy)

A Look At Pre-2008 Equity Market Valuations

We hear a lot of market commentators refer to long-term average P/E multiples for the U.S. stock market when trying to assess what “fair value” might be. It is interesting to me that oftentimes the time periods they choose to focus on often map right on to the desired conclusion they want to numerically support.

For instance, the trailing 10 -year average P/E for the S&P 500 index is about 19.5. As a result, bullish Wall Street strategists can easily, and usually without much pushback, come on TV and pronounce the market cheap (at current prices - 3,735 - and current 2022 profit estimates - $224 - the market P/E is about 16.7x).

Of course, over the last 10 years we have had record-low interest rates that some thought would remain forever, but we are seeing that might not be the case. As an example, over the last 11 years, the 10-year U.S. treasury bond closed below 2% a whopping 5 times. Not likely we see a similar path over the next 11 years, with the 10-year pushing 3.5% today.

So if our goal should be matching historical data with current economic conditions, my attention turns to the period of 2002-2007, an 5-year run where the 10-year bond largely traded between 4 and 5 percent. What was the average market P/E ratio during that time? About 17 times. Using 2022 S&P profit estimates we arrive at a fair value of 3,800 - a mere 2% above current levels.

As we all know, in the near-term valuations overshoot to the downside and in recessions profits can take a quick one-year tumble. That dual uncertainty tells us that stocks could certainly go materially below that level for a few quarters without surprise. But over the intermediate to long term, even if higher interest rates persist, the overvaluation situation seems to have already largely corrected itself, as it always does.

The biggest question for me is where earnings go from here. Near term? Anyone’s guess. Longer term? History tells us not to bet against U.S. companies and their ability to grow profits over the economic cycle. Consider this: in the last 60 years the S&P 500 index has seen its cumulative earnings drop in back-to-back years just 4 times. As a result, investors who take a multi-year view rarely do poorly provided they don’t severely overpay for equities.

I know rates are most in focus right now, but I think the key to the next 12-24 months in the market will be how S&P earnings hold up relative to the all-time record $208 posted in 2021.

Are Financial Markets Getting Even Less Predictable in the Near Term?

Earlier in my investment management career it was not uncommon for me to raise a fair amount of cash, say 10-20%, in client accounts when I thought the equity market was overheated. The idea was that I would have plenty of firepower when prices dropped and bargains were abundant. Over the years the data suggested that such a move was rewarding, at best, half the time. Too many instances, though, resulted in prices rising enough before they fell that the cash positions at best offered no alpha.

Don’t get me wrong, I have always been in the camp that market timing in the near term is difficult (hence I would never go to 50, 75, or 100 percent cash), but I learned that mean reversion, while a real thing, could not really be consistently exploited profitably even on just a small part of a portfolio. As a result, cash balances in my managed accounts now reflect the number of interesting investing opportunities I see out there, rather than overall market levels.

As I have spoken with clients this year, I think 2021 has solidified the argument against market timing even more, if that’s possible. Profits for S&P 500 companies this year are currently on track to come in roughly 30% above 2019 levels. And that result has not happened because the pandemic suddenly waned. In fact, we are seeing a lot of data that would suggest corporate profit headwinds; retail supply constraints, a lack of qualified labor, and a chip shortage - to name a few - all of which are profit margin-negative.

Despite such strong profit growth, interest rates remain very low with the 10-year bond yield hovering below 1.5%. The end result is an S&P 500 that fetches 23 trailing earnings after surging for most of the year. Who would have been able to predict that? It seems to me even fewer people than would have done so in more normal economic times.

The current inflation story reinforces the point even more; that short-term market movements are getting even less predictable than in the past. And that’s certainly saying something. We just learned today that consumer prices rose by more than 6% in October, a 30-year high. Remember how one of the main jobs of the Federal Reserve is to raise interest rates to keep inflation subdued? Would any short-term investment strategist suggest that 6% inflation would not result in higher interest rates and thus lower stock valuations? And yet, here we sit with the Fed Funds interest rate sitting at zero. Not just an average rate. Not just a below average rate. But zero.

I didn’t come into 2021 trying to predict the economy and the markets and thank goodness for that. For those who still do try that sort of thing, I think 2021 has taught us that a very tough job is getting near impossible, if it wasn’t there already.

So what to do? Throw up our hands, of course. But in conversations with clients I find myself saying “I have no idea” more often than ever. Some may find that disappointing, especially coming from an industry professional, but if my track record predicting stock prices, interest rates, or other economic metrics six months out was unimpressive before the pandemic, imagine how subpar it would be now. I much prefer to just sit back and try to invest in undervalued companies regardless of the macro backdrop and I think my clients are best served by that as well.