Patience tends to be handsomely rewarded on Wall Street, as any long-term chart of the Dow Jones Industrial Average (^DJI 0.01%), S&P 500 (^GSPC 0.24%), and Nasdaq Composite (^IXIC 0.26%) shows. However, the short-term movements in these major U.S. stock indexes are far less predictable.
In just a two-year stretch, the Dow Jones, S&P 500, and Nasdaq Composite have screamed to new highs, plunged into a bear market, and come roaring back -- at least for the S&P 500 and Nasdaq Composite. On a year-to-date basis, through June 26, 2023, the broad-based S&P 500 and growth-driven Nasdaq Composite were higher by 12.7% and 27.4%, respectively.
While a running of the bulls is typically welcome news for investors, a deeper dive into what's driving the S&P 500 and Nasdaq Composite higher reveals that Wall Street has a "big" problem on its hands.
Image source: Getty Images.
Wall Street's big breadth problem historically hasn't ended well
By one definition, the S&P 500 and Nasdaq have officially entered a new bull market. Both indexes have decisively rallied more than 20% from their 2022 bear-market closing lows. But upon closer inspection, a narrow group of megacap growth stocks is driving the lion's share of this rally.
In one respect, more credence should be given to larger businesses that play a critical role in the U.S. and global economy. In other words, if Apple (AAPL +1.00%), the largest company in the market cap-weighted S&P 500, crushes or vastly misses Wall Street's sales or profits expectations, it should have more of an impact than if Newell Brands, the smallest component of the S&P 500, surpasses or falls short of expectations. To some degree, market-cap weightings serve the purpose of offering a fair picture of what's going on with equities.
But when a narrow band of the largest stocks is supporting the broader market and leaving a majority of other companies to eat their dust, history shows us that bad things tend to happen.
The forward P/E ratio for the 10 biggest names in the S&P500 by market cap is currently 28.5x....this compares to 16.3x for the 'other' 490 stocks in the index. pic.twitter.com/MDGndsJ404
-- Longview Economics (@Lvieweconomics) June 21, 2023
Recently, London-based financial markets research house Longview Economics published the tweet you see above that compared the forward price-to-earnings (P/E) ratio of the 10 largest companies of the S&P 500 to the forward P/E ratio of the remaining 490 companies. Note: While the S&P 500 is comprised of 500 representative companies, a handful of companies have multiple share classes (e.g., Alphabet with its Class A (GOOGL) and Class C (GOOG) shares), which is why the index has 503 components instead of the expected 500.
As of June 2, 2023, the forward P/E ratio of the S&P 500's 10 biggest companies was a lofty 28.5, which compares to just 16.3 for the other 490 companies that make up the index. Year-to-date gains of 178% for Nvidia (NVDA +0.19%), 131% for Meta Platforms, 95% for Tesla (TSLA 1.98%), 52% for Amazon, 43% for Apple, 37% for Microsoft, and 34% for both classes of Alphabet shares are wildly skewing the performance of the S&P 500 and Nasdaq Composite.
Since 1995, there have been a couple of instances where the S&P 500's 10 largest stocks by market cap had forward P/E ratios that diverged considerably from the remaining 490 companies in the index. This occurred immediately prior to the dot-com bubble bursting, again in 2018, in 2021 during the COVID-19 pandemic, and once more in 2023. In the previous three instances where market breadth was skewed toward Wall Street's biggest companies, the S&P 500 shed 49% (dot-com bubble), 20% (fourth quarter of 2018), and 25% (2022 bear market) of its value.
Historically speaking, a significant divergence in forward P/E valuations between Wall Street's largest companies and the remaining companies usually spells serious trouble for stocks.
Valuations are a concern, too
Aside from the stock market not responding particularly well when a small group of companies is leading the Dow, S&P 500, and Nasdaq Composite higher, the valuations for some of the 10 largest S&P 500 companies are very difficult to get behind.
NASDAQ: NVDA
Key Data Points
For example, I doubt any Nvidia optimists are complaining about the company's shares catapulting higher this year on the prospect of rapidly growing demand for artificial intelligence (AI)-inspired graphics processing units used in data centers. Nvidia's fiscal second-quarter sales guidance of $11 billion was 53% higher than the consensus among Wall Street analysts and put the scope of AI demand into perspective.
However, next-big-thing investments have a pretty poor initial track record. Over the past 30 years, every next-big-thing trend went through an initial bubble phase. The internet, genome decoding, business-to-business commerce, 3D printing, cancer immunotherapies, cannabis, blockchain technology, and the metaverse are all examples of trends or innovations where investor expectations wildly outpaced initial uptake. Chances are that AI isn't going to be any different, which makes Nvidia's $1 trillion market cap a tough sell for optimists.
It's a similar story for Tesla. Yes, Tesla has revolutionized the electric-vehicle (EV) industry and looks to have enough capacity to reach 2 million or more EVs annually once it's fully optimized production at its four current gigafactories. It's also been generating a generally accepted accounting principles (GAAP) profit for three years and counting.
NASDAQ: TSLA
Key Data Points
At the same time, Tesla has struggled to become anything more than an automaker. Its foray into solar panels has, arguably, been a failure, and the company's services segment generates low margins. For better or worse, Tesla is reliant on EV sales and leases to move its profit needle. With competition picking up in a big way and the company cutting prices on its EVs a half-dozen times in 2023, automotive margins are bound to shrink. That's not a particularly attractive recipe for a company with a forward P/E ratio of 50 in an industry with P/E ratios that typically hover between 6 and 8.
Even Apple's valuation is questionable. Although it's a company that checks all the right boxes for new and tenured investors, it's expected to report a low-single-digit decline in sales and profits in fiscal 2023 (Apple's fiscal year ends in late September). What makes this sales slowdown even more of an eyesore is that Apple had the benefit of above-average inflation as a tailwind and is still expected to report a year-over-year sales decline. It's not an inexpensive company at 31 times Wall Street's consensus earnings in fiscal 2023.
Image source: Getty Images.
Wall Street's "big" problem has a seemingly foolproof solution
If history were to repeat itself, there's a reasonable chance we'll see the forward P/E gap between the largest 10 companies in the S&P 500 and the remaining 490 companies narrow in the coming quarters. While it's possible the remaining 490 companies could rally and play catch-up, history suggests it's far likelier that the outperformance in megacap growth stocks will eventually fade.
But it's also important to recognize that short-term stock movements are incredibly difficult to forecast with any certainty. That's why the solution to Wall Street's "big" problem is to remain focused on the long term.
For instance, there have been 39 double-digit stock market corrections in the S&P 500 since the start of 1950. That works out to a decline of at least 10%, on average, every 1.88 years. If you aren't approaching your investments with a long-term mindset, it can be frustrating to trade these potentially wild short-term swings in the broader market.
Now, widen the lens quite a bit and examine the chart of the S&P 500 since the start of 1950. As you can see, the vast majority of the 39 stock market corrections over the past 73 years aren't even visible, or perhaps show up as nothing more than blips. That's because every stock market correction, bear market, and crash throughout history, save for the 2022 bear market (for the time being), has eventually been cleared away by a bull market rally. Historically speaking, buying these dips as an index fund investor has always been a smart move.
A rich dataset from market research company Crestmont Research paints a similar picture. Crestmont looked at what the total return, including dividends, would have been if an investor, hypothetically, purchased an S&P 500 tracking index and held that position for 20 years. Even though the S&P didn't come into existence until 1923, many of the same components existed in similar indexes (e.g., the Dow Jones Industrial Average), which allowed Crestmont to back-test its dataset to 1900 and analyze 104 ending years (1919-2022) of data.
Crestmont Research was able to show that all 104 ending years produced a positive total return. In other words, the seemingly foolproof solution to near-term uncertainty and poor market breadth is to stay the course and have a long-term investing mindset.
