Basketball playoffs are here. And whether your team made the playoffs or went home early, there's always a lot of excitement as to who will win the championship, as well as which teams will draft the best new prospects.
Sports fans know that every great dynasty eventually comes to an end. But the organizations that foster good scouting, coaching, and training have what it takes to rebuild a team and work toward future success.
Here's what the life cycles of different basketball teams can teach you about bull markets and bear markets.
The championship team
Imagine you have a stock market that resembles a championship-caliber team that had just won it all. Chock full of talent, there's reason to believe they can win another chip. And even if they don't, they'll probably come close, and the season will be deemed a success.
This scenario is like an early- or mid-stage bull market. In this type of market, interest rates are probably low, but not too low. That way, the Federal Reserve can lower them if it needs to stimulate the economy. Productivity is high, and growth is good. Companies are growing into their valuations, much like athletes that live up to their hype. International trade is booming, and productivity is on the rise. But all good things must come to an end. The stock market is rarely that easy. And just as most professional basketball teams have weaknesses in their starting five, so too do most stock markets have short-term issues that can lead to heightened volatility.
A well-rounded veteran team vs. a rebuilding team
Now imagine a much more challenging scenario. You have two basketball teams and must decide which team will have more total wins over the next decade.
Team one is coming off a playoff year. Not a championship year but a good run, nonetheless. They have tons of veteran talent and postseason experience. However, the team is aging, and big contracts from the all-star power forward and first-ballot hall-of-fame point guard are eating into the salary cap, which makes it harder to sign younger players. What's more, years of winning records and division titles have resulted in lower draft picks.
Team two is coming off a year where they had one of the worst records in the league. But team two has good coaching, a savvy general manager, young talent, and draft picks on the way.
The analogy is that team one is a late-stage bull market, like the one we are probably in now. Whereas team two is a bear market, where valuations are low but long-term upside is typically high.
Bear market advantages
I don't know which team you would predict would win more games over the next 10 years. But personally, I'd take the younger team with the bad record -- the bear market -- all day long. The reason is that bear markets make excellent companies inexpensive and unproven companies dirt cheap. It may sting for a while. But with so much potential, you can really let time work in your favor.
By contrast, the high-salaried veteran team may be OK for a while. But there's only so much upside when a team is that mature, much like a market where valuations are relatively high, and growth is slowing.
There's reason to believe that the market stage we are in now is like this aging veteran team. Consider that on Jan. 1, 2017, the combined value of Microsoft (MSFT -0.32%), Apple (AAPL -1.00%), Alphabet (GOOG -0.02%) (GOOGL -0.09%), Amazon (AMZN 0.23%), Tesla (TSLA -2.76%), Meta Platforms (META -0.43%), and Nvidia (NVDA 0.35%) was $2.4017 trillion. On Jan 1, 2022, the value of Microsoft alone was $2.522 trillion -- worth more than those seven companies combined just five years prior.
The combined value of these seven companies was $11.786 trillion on Jan 1, 2022, a nearly fivefold increase in just five years. $9.384 trillion in value was created from these seven companies alone in five years, which is about what the entire S&P 500 was worth in the summer of 2010.
This isn't to say that these seven companies can't get bigger. They probably will and could even continue to beat the market in the process. Rather, the point is that it's going to be hard for Microsoft to add another $2 trillion in market cap in the next five years. Or Apple to add $2.3 trillion in market cap. Or Nvidia to go up another 12-fold in the next five years.
Consider a glass-half-full perspective on bear markets
The truth is that no one knows when the next bear market will come or why it will come. Rather, what we do know is that the compound annual growth rate (CAGR) of the S&P 500 since 1965 has been 10.5% per year. We also know that starting with $0 and investing $10,000 every year into a retirement account at a CAGR of 10% for 50 years equates to $11.64 million. That includes all the ups and downs and crazy volatility that the stock market throws at you.
It took years for the Nasdaq Composite to rebound from its dot-com burst or for the S&P 500 to reach a new high after its financial crisis plunge. But eventually, they did.
So next time we enter a bear market, whether that's this year, a few years from now, or a decade from now, just remember to take a glass-half-full perspective -- particularly if you're a younger investor or haven't reached your peak earning years. And if you're retired, at least you can take solace knowing lower equity prices will allow future generations the chance to buy assets at a cheaper price.