You Could Soon Be Asking Yourself 'What Was I Thinking?'

The Fed isn't this important... Nvidia is the definition of mania... Semiconductors are rapidly rising... The 'Top Dog' stocks right now... 'What was I thinking?'…

I (Dan Ferris) am sick of hearing and talking about the Federal Reserve...

Earlier this week, the Fed held its latest Open Market Committee meeting. And on Wednesday, Fed Chair Jerome Powell announced the Fed's decision on monetary policy.

The Fed once again voted to keep the benchmark fed-funds rate steady in a range of 5.25% to 5.5%.

The media and investors were hanging on Powell's every word.

The Fed is supposed to be the bank of last resort, along with the top banking regulator in the country. It's not supposed to be the center of financial market activity, unless there's a massive banking crisis underway. The fact that we're all obsessed with it suggests something is very wrong in the world.

Paraphrasing legendary financial newsletter writer Jim Grant, the Fed's popularity feels like putting Major League Baseball umpires on the cover of Sports Illustrated.

The market responded to the Fed's decision as you might expect. Everything went up on Wednesday: stocks, bonds, gold, silver, copper, and oil.

Stocks and bonds rising together suggests that many investors still believe the absolutely wrong idea that rate cuts are good and that the Fed will cut rates soon – even though the annual rate of inflation (based on the consumer price index) – is above 3% and unemployment is hovering around half-century lows.

However, oil and metals rising suggests that some people are calling BS on the idea that inflation is retreating and that rate cuts are anywhere on the horizon.

The Fed is simply not this important. The 10-year Treasury yield doesn't drop 3% in one day because the Fed might cut rates. It drops because people think they'll be a lot safer owning Treasurys for 10 years than owning stocks at exorbitant valuations. In short, people turn to Treasurys when they think the economy is weakening or that stocks may be egregiously overvalued.

And speaking of overvalued stocks...

'One Ring to rule them all'...

Lord of the Rings fans will recognize that phrase, which refers to the "One Ring" of power at the center of J.R.R. Tolkien's epic tale of hobbits, elves, wizards, and other creatures in the mythical land of Middle-Earth.

The ring is one of 20. The other 19 rings include three for the elves, seven for the dwarves, and nine for "the race of Men, who, above all else, desire power." The One Ring was created by an evil dark lord to give him power over everyone else. And death and destruction follow it. The sinister inscription on it reads:

One Ring to rule them all, One Ring to find them,
One Ring to bring them all and in the darkness bind them.

The Lord of the Rings tells the epic tale of a quest to destroy the One Ring once and for all.

It's just too hard for me to think of the One Ring and not think about chipmaker Nvidia (NVDA).

Every decade or so, one stock captures the market's imagination. And sometimes that stock becomes the most valuable company in the world. It's usually the result of an epic bull run that has become an out-and-out mania. Everyone chases the "one stock," but it usually ends badly...

I don't need to cite specific valuations to declare Nvidia an all-out mania stock. All I need to show you is the following photo of Nvidia co-founder and CEO Jensen Huang autographing a woman's chest...

This photo should appear in the dictionary next to the word "mania." CEOs are not rock stars. And when they're treated like rock stars, it might be a sign that they've failed.

Let me explain...

This is what Huang has said about the AI craze driving demand for his company's products:

Smart people focus on the right things.

The potential of AI is limitless, and we're just scratching the surface of what it can do.

The automation of automation, the automation of intelligence, is such an incredible idea that if we could continue to improve this capability, the applications are really quite boundless.

AI is not just a technology, it's a tool for solving some of the world's biggest problems, like climate change and disease.

Maybe it sounds like the typical puffery of a CEO excited about his company's success. And Nvidia did invent the graphics processing units ("GPUs") that revolutionized modern gaming. Now, that GPU is helping AI grow exponentially. Those are amazing achievements.

I just think that when a company is in hypergrowth mode, a CEO has a duty to shareholders to point out that hypergrowth never lasts. Nvidia has reported triple-digit year-over-year sales growth in each of the last four quarters.

In the last two quarters, revenue grew more than 260% compared with the same quarter the previous year. That sort of skyrocketing growth tends to end about as quickly as it arrives. And a hypergrowth company in the highly cyclical semiconductor industry deserves an extra dose of caution. Nvidia's hypergrowth is virtually guaranteed to end right when everybody is most certain it'll continue.

And yet, Huang is touting how smart Nvidia is and claiming AI is "limitless" with "boundless" applications that can solve a problem like climate change.

He's not the first CEO to get caught up in his company's great success...

And you may call me naïve to expect any CEO to behave otherwise. But I can't help thinking about Sun Microsystems former CEO Scott McNealy's famous confession in a March 2002 Bloomberg interview.

[T]wo years ago we were selling at 10 times revenues when we were at $64. At 10 times revenues, to give you a 10-year payback, I have to pay you 100% of revenues for 10 straight years in dividends. That assumes I can get that by my shareholders. That assumes I have zero cost of goods sold, which is very hard for a computer company. That assumes zero expenses, which is really hard with 39,000 employees. That assumes I pay no taxes, which is very hard. And that assumes you pay no taxes on your dividends, which is kind of illegal. And that assumes with zero [research and development] for the next 10 years, I can maintain the current revenue run rate. Now, having done that, would any of you like to buy my stock at $64? Do you realize how ridiculous those basic assumptions are? You don't need any transparency. You don't need any footnotes. What were you thinking?

It has become a famous quote about investors' irrational behavior at the top of a bubble. But nobody ever tells you what he said right after that when the Bloomberg interviewer asked him what he was thinking:

I was thinking it was at $64, what do I do? I'm here to represent the shareholders. Do I stand up and say, "Sell"? I'd get sued if I said that. Do I stand up and say, "Buy"? Then they say you're [Enron Chairman] Ken Lay. So you just sit there and go, "I'm going to be a bum for the next two years. I'm just going to keep my mouth shut, and I'm not going to predict anything." And that's what I did.

In short, McNealy clearly implied that telling folks to buy his own company's stock when it was too expensive could be seen as one step shy of committing fraud. Fearing the legal implications of telling them to sell, he just got really quiet when he knew the stock was ridiculously priced.

Nowadays, we know a CEO can say his company's stock is too expensive and not get sued. Jamie Dimon recently told JPMorgan Chase (JPM) shareholders that the company wouldn't be buying back stock at current levels, implying that share buybacks would destroy value because the stock is too expensive. Even Elon Musk told everyone that Tesla's (TSLA) stock price was too high in 2020. To my knowledge, neither CEO was sued for his comments. Neither CEO told investors to sell. But if you tell shareholders the stock is expensive, they get the message.

There's also the perennial example of Warren Buffett, who has been cautioning shareholders for years not to expect the incredible returns that Berkshire Hathaway has delivered in the past.

I think Huang knows AI is a huge mania right now... that Nvidia is exorbitantly expensive... and that its hypergrowth mode won't last nearly as long as many folks believe. He knows folks buying the stock right now are counting on something that usually doesn't play out well.

It's his job as CEO to temper expectations – while maintaining a positive view of the company's products, people, and mission. But I only hear the positives from Huang. I don't hear the tempering.

To be fair, it's the whole semiconductor industry...

Todd Sohn of Strategas Asset Management recently pointed out that semiconductors now make up roughly 11% of the S&P 500's total market cap. That's the industry's highest level at any time in at least 20 years. And it's not necessarily a good thing.

Sohn published charts showing that the market cap of the dominant industry in the Index – which often contains the "one stock" at the time – usually peaks at the top of bubbles featuring that industry.

For example, Internet hardware was roughly 25% of the S&P 500 when Cisco Systems (CSCO) was the "one stock" with a peak market cap of $569 billion in 2000. But from 2000 to 2015, financial analyst Mark Neuman says the stock price went on to fall by more than half – despite Cisco seeing revenues jump 4 times in that span. So even if a company keeps growing at a rapid rate, being expensive at the top of a bubble is enough to destroy shareholder returns for years to come.

In 2008, energy dominated at more than 15% of the S&P 500 when ExxonMobil (XOM) was the "one stock" with a market cap of $456 billion. Its stock went on to fall around 40% over the next two years.

Software has been the dominant industry since about 2016, with Microsoft (MSFT) currently occupying the top weighting in the S&P 500 with a market cap of around $3.3 trillion. As we write, Apple (AAPL) is the second weighting and Nvidia is third, both with market caps of around $3.25 trillion.

But as we write, Nvidia is up more than 160% since January 1, with Apple up around 11% and Microsoft up around 18%. Nvidia is also riding the AI boom and has a CEO who's failing to temper expectations. So neither Microsoft nor Apple is the object of mania. As Sohn showed, Microsoft's industry looks like it's on its way out as the top S&P 500 weighting, with Nvidia's industry rapidly rising.

Nvidia may yet take the top spot in the S&P 500 – and the world. Its market cap has exceeded Apple's twice so far. And the fanatics buying Nvidia could push it above Microsoft's to take first place. If that happens, I'll probably get even more bearish than I already am.

The top five mega-cap stocks right now...

Sohn also discussed the weights of the top five stocks in the S&P 500 today. From 1990 to 2020, the top five stocks routinely accounted for less than 15% of the index. They surged to 24% in August 2020 and recently hit an all-time-high weight of 27.1% of the index.

Folks contributing to 401(k) accounts every paycheck are putting more than a quarter of their savings into just five companies, week after week.

And you're no better off with international equity funds, according to the X account Global Markets Investor. It reports that the 10 largest U.S. stocks now account for more than 13% of global stock market capitalization – well above the dot-com-era peak weighting of 9.9%.

Everywhere you look, everybody is buying way too much of just a few mega-cap stocks... and most of them have no idea they're doing it.

History has shown that buying the largest market cap companies in the index is not a great strategy. I've noted Research Affiliates' "Top Dog" stocks before. It's worth mentioning again.

In their 2012 paper titled, "The Winners Curse: Too Big to Succeed?," authors Rob Arnott and Lillian Wu found:

For investors, Top Dog status – the #1 company, by market capitalization, in each sector or market – is dismayingly unattractive. We find a statistically significant tendency for top companies in each sector to underperform both the overall sector and the stock market as a whole. In an earlier U.S.-only study, we found that 59% of these Top Dogs underperformed their own sector in the next year, and two-thirds lagged their sector over the next decade. We found a daunting magnitude of average underperformance, averaging between 300 and 400 [basis points] per year, over the next 1 to 10 years.

So if you want to underperform both the market and the semiconductor industry over the next decade, by all means, plow your savings straight into Nvidia. And keep putting 27% of your savings into the top five U.S. stocks... or 13% into the top 10 U.S. stocks.

Just make sure you don't wind up sitting at the kitchen table gaping at your massive losses in a few years... asking, "What was I thinking?"

New 52-week highs (as of 6/13/24): Apple (AAPL), Alpha Architect 1-3 Month Box Fund (BOXX), Crocs (CROX), Nuveen Preferred & Income Opportunities Fund (JPC), Eli Lilly (LLY), Microsoft (MSFT), Micron Technology (MU), Nuveen California Quality Municipal Income Fund (NAC), Neuberger Berman Next Generation Connectivity Fund (NBXG), ProShares Ultra QQQ (QLD), Invesco S&P 500 Equal Weight Technology Fund (RSPT), VanEck Semiconductor Fund (SMH), ProShares Ultra S&P 500 (SSO), ProShares Ultra Semiconductors (USD), Vanguard S&P 500 Fund (VOO), and the short position in Teladoc Health (TDOC).

A quiet mailbag today. As always, let us know what's on your mind with an e-mail to feedback@stansberryresearch.com.

Good investing,

Dan Ferris
Eagle Point, Oregon
June 14, 2024