'The Price of Prosperity' Will Soon Catch Up to These Market Darlings
Editor's note: It's impossible to predict what will happen in the markets at any moment...
That's why it's critical to make sure you're prepared for as many outcomes as possible. And according to Extreme Value editor and frequent Digest contributor Dan Ferris, a key way to achieve this is with "true diversification" of your portfolio among several asset classes.
But in order to fully prepare for what's to come in the markets, you must also understand why stocks are so overvalued today... and where they're likely to go from here.
In today's Masters Series – adapted from the January 7 and February 24 issues of our free DailyWealth e-letter – Dan explains why even the "safest" businesses in the world aren't immune to wild swings... and why he believes last year's unpredictable ride isn't over yet...
'The Price of Prosperity' Will Soon Catch Up to These Market Darlings
Mature, prosperous nations are like rich old men.
When they were young, poor, and hungry for success, they had little to lose and everything to prove. So they worked, risked, and managed their way to a fortune.
Now old and rich, they have much to lose, nothing to prove, and tend to avoid risk-taking.
Think Ebenezer Scrooge. He started out as an ambitious yet carefree young man and wound up rich, stingy, and bitter (before Jacob Marley and the three spirits showed up, of course).
Economist and author Todd Buchholz's 2016 book, The Price of Prosperity: Why Rich Nations Fail and How to Renew Them, addresses this tendency of rich nations to fail due not to economic failure, but to the problems brought about by economic success.
The "price of prosperity" dynamic also influences successful companies. Their success attracts younger, smarter, hungrier competitors who are only too eager to take all the risks and make all the decisions that the established businesses are too scared to make.
I've been warning investors about this since 2017. As I've said, the greatest businesses in the world can generate poor returns – or even big losses.
And you don't have to go far back in time to see how such businesses – and their shareholders – paid dearly for the prosperity they generated...
The five largest stocks by market cap on March 31, 2000 – the peak of the dot-com bubble – were General Electric (GE), Cisco Systems (CSCO), ExxonMobil (XOM), Pfizer (PFE), and Microsoft (MSFT).
Back then, everybody thought they were the most fantastic businesses in the world. They were the safe, blue-chip, "no-brainers"... They were "one-decision stocks" because the only decision you needed to make was to buy them – with no need for deep, fundamental research – and by implication, never even consider selling them.
Reality proved those ideas wrong. All five companies were decimated when the bubble popped. Peak to trough, GE fell 63%, Cisco fell 89%, ExxonMobil fell 36%, Pfizer fell 48%, and Microsoft fell 64%.
Microsoft finally eclipsed its dot-com highs after 17 years. And ExxonMobil soared along with oil prices in the years following the dot-com crash. But the other three have yet to break even... two decades later.
These companies have paid for their former prosperity by generating disappointing results and disappointing investment returns...
For example, GE – now a shadow of its former self – fell so far from grace that one famous analyst called it "a bigger fraud than Enron." The manipulations that helped GE generate steadily rising earnings and a rising stock price also sowed the seeds of its inevitable downfall. The financial results weren't nearly as good as the company had reported for several years. The market found out about it, and the stock tanked.
And Cisco and Pfizer are still good businesses that have offered chances to profit over the past 20 years – but they have not lived up to the "one decision" promise.
The dot-com-era doubters were mostly right. I suspect today's doubters will be proven right sooner rather than later, too. And you can count me among them.
The price-of-prosperity dynamic is bearing down hard on the most successful companies of our era...
I'm talking about companies like Apple (AAPL), Amazon (AMZN), Microsoft, Facebook (FB), and Tesla (TSLA).
These are the no-brainers and one-decision stocks of today. They're the ones nobody questions. They're the businesses everybody and their brother believes will deliver stellar results and investment returns forever.
When the COVID-19 pandemic hit our shores a year ago, investor and writer Howard Marks' proverbial "pendulum of investor psychology" careened toward extreme pessimism. Investors wanted out of stocks, and panic selling ensued.
Now, the pendulum of investor psychology has swung to the other extreme...
Our research indicates the gap between expectations and stock fundamentals has narrowed so much that most businesses are now trading at, or even above, their intrinsic value estimates. (Intrinsic value is an estimate of the highest price a business would likely command, based on its future free cash flow generation.)
When businesses are widely trading near intrinsic value, their upside potential is limited. This is particularly true of the largest tech stocks comprising the Nasdaq 100 Index. That index has soared more than 75% since its March 2020 low, outperforming the S&P 500 Index by about 10 percentage points.
In other words, today's tech darlings are leading the mania. Expectations are high. And we must prepare for the possibility of a significant move lower. (Just take a look at the recent downward moves for the Big Tech names, which have been falling as bond yields rise.)
Investors in Big Tech names like Apple and Amazon are doing today what they've done for much of the past decade – assuming the next several years will look a lot like the recent past.
Generating strong top-line growth year after year while also maintaining solid margins is no small feat. The fact that many Big Tech names have been able to accomplish this explains why they've been exceptional investments over the past decade.
Just don't expect it to last forever...
Today, the U.S. stock market is more expensive – and therefore riskier – than at any time in the past century. You must understand that risk... because last year's roller-coaster ride isn't over yet...
The stock market soared 68% off its March bottom through the end of last year. Would you have thought new all-time highs were even a remote possibility after that precipitous drop?
Would you have thought that despite a raging pandemic, political upheaval, and civil unrest, stocks would surge to their most expensive valuation in history – even more expensive than the 1929 and 2000 market tops?
I've occasionally said that a "wider range of outcomes" for the price of a given asset indicates higher risk. For example, there's a much wider range of outcomes for small-cap mining stocks (which can soar hundreds, even thousands of percent – or collapse entirely) than for Treasury bonds (which pay a little less than 1.5% a year for 10-year bonds today).
And as I said yesterday, it's important to prepare for all of those possible outcomes.
The stock market has made higher highs since I got bearish in 2017... But it has also made lower lows. In other words, a wide range of outcomes occurred.
The more expensive stocks become, the riskier they are to own. And that's what we've seen in the market over the past year...
The best two metrics to demonstrate how expensive stocks are today are the S&P 500 price-to-sales (P/S) ratio and the ratio of total U.S. market cap to U.S. gross domestic product ("GDP").
Over the past century or so, whenever the P/S ratio has been high, the market has tended to perform poorly – sometimes for many years. At the peak of the dot-com bubble in March 2000, the P/S ratio was 2.3. Today, it's about 2.8.
The total market-cap-to-GDP ratio was pioneered by value guru Benjamin Graham and often cited by his prized pupil, Warren Buffett. It, too, has never been as high as it is today. It peaked at 140% in 2000 and 105% in 2007. Now, it's at roughly 185%.
I also follow the stock market valuation work of economist and asset manager John Hussman of HussmanFunds.com. He tracks five metrics – including the P/S ratio – that have all correlated negatively over the past century with subsequent 10- and 12-year S&P 500 performance. Roughly 90% of the time when they've been high, the S&P 500 has performed poorly for a decade.
Back in December, Hussman wrote...
Presently, I expect that the completion of this market cycle is likely to involve a loss in the S&P 500 on the order of 65-70%. I realize, of course, that this sounds insane. The problem is that this projection is fully in line with a century of evidence and is consistent with the extent of market losses that would be run-of-the-mill given present valuation extremes.
Hussman estimates that a portfolio of 60% S&P 500 stocks, 30% long-term Treasury bonds, and 10% Treasury bills will lose 1.7% per year for the next 12 years. He estimates the S&P 500 by itself will lose 3.6% per year for the next 12 years.
Asset manager Jeremy Grantham's firm, GMO, has studied a couple dozen asset bubbles throughout history. It also publishes seven-year return forecasts for various asset classes. Grantham recently called the current market a "'real McCoy' bubble" and added, "It's truly crazy."
GMO's seven-year annual return estimates for all U.S. equities and bonds, international large-cap equities, and international bonds are negative. Its only attractive forecast is for value stocks in emerging markets, at 5% per year.
With stocks more overvalued than at any time in the past century, it's time to plan accordingly. Risk is high today... And we'll likely see years of underperformance when this bull market ends.
Good investing,
Dan Ferris
Editor's note: Dan has uncovered a stock that he says is "one of the greatest businesses I've ever found." Right now, it's trading at an excellent valuation for long-term investors who want to potentially make up to 10 times their money in the next five to 10 years.
Dan has known this company's leaders for years. And he said he has rarely found a better, more capital-efficient business model in his 23-year career writing financial newsletters.
So recently, Dan invited a camera crew to his house... And he went on record with the full story of why he loves this business so much. Get all the details directly from Dan right here.