Overvalued or New Paradigm?

The article “Overvalued or New Paradigm?” first appeared on Alpha Architect blog.

Abstract: “What you don’t know about investing, is the investment history you don’t know” is one of my favorite expressions. It embodies some core investment principles: market cycles tend to repeat themselves, though often with variations; understanding the past is crucial for predicting the future; and investors who study history make more informed decisions.

The potential for artificial intelligence (AI) to revolutionize industries and generate substantial profits has fueled a speculative frenzy, with investors pouring money into companies perceived as AI leaders. This euphoria, while potentially rewarding for early adopters, carries risks as inflated valuations can lead to sharp market corrections if AI’s progress fails to meet lofty expectations.

The speculative frenzy, aided by the fear of missing out (FOMO), has been fueled by the spectacular performance of the “Magnificent Seven.” The following table, with information from Morningstar, shows the market capitalization of the Mag 7, their annualized 5-year returns, and their current P/E ratio as of July 24, 2024.

The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained.  Indexes are unmanaged and do not reflect management or trading fees, and one cannot invest directly in an index.

Their average 5-year annualized return of 38.7% is almost triple that of 13.3% annualized return of Vanguard’s Total Stock Mkt Index Fund (VTSMX). The spectacular performance pushed the P/E’s of the Mag 7 to an average of 45.9, more than double the 21.5 P/E of VTSMX.

The gap in performance and valuations has raised concerns about their valuations and whether euphoria and speculation has led to overvaluation. It has led me to dig up an article I wrote in January 2000, just before the bubble burst in March 2000. It provides a history lesson. I hope you find it helpful.  

Bubble or New Paradigm

Without question the topic of greatest debate among investors, including investment professionals, and financial economists, is whether or not the market, and the technology sector in particular, is overvalued. There are two very strong conflicting views regarding not only the current valuation of technology stocks, but also the valuation of the entire asset class of large-cap growth stocks. One side, I’ll call the “new paradigm” or “it’s different this time” school. The other side, I’ll call “the been there, done that” school. Its theme is those that don’t learn from the past are doomed to repeat the same mistakes. No two sides could have more different viewpoints. To understand each side, let’s imagine a dialogue between the two schools.

New Paradigm: It’s a new world order. It’s the new, new thing. Investors should own great companies at any price. Never discard the right company just because the price is too high.

Been there, done that: That is exactly what investors were saying in the late 1960’s. There was a group of stocks called the Nifty-Fifty—roughly 50 large-cap growth stocks with P/E ratios of about 50 or more. They were mostly high-tech stocks like IBM, Sperry Rand, NCR, Control Data, Xerox, Honeywell, Polaroid, etc. Like today’s Ciscos, they were called one-decision-just buy-at-any-price and hold forever stocks. Within two years many of them had fallen by 80-95%. The only differences are that today investors are buying at even higher price-to-earnings or price-to-sales ratios and they are buying anything that is Internet related. Then it was anything electronics related. Now if it has an E- in its name it gets billion dollar valuations from investors that can’t even tell you what the company does, let alone how they are going to make money doing it. Then investors bought anything with the suffix “tronics” or “onics.”  Just like today, the IPO market was hot and companies were changing names just to have the correct suffix. Been there, done that.

New Paradigm: But it’s different this time. The Internet is changing the world. It’s a great revolution, supercharging the economy.

Been there, done that: The story is the same. In the sixties it was the same technology story. Many companies eventually succeeded, and many failed. But most failed to justify the valuations placed on them. We also see no reason to think that this revolution will have any bigger impact than the previous society changing inventions such as the automobile, air travel, TV and Radio (RCA hit 114 in 1929 and NEVER recovered to that level right up until it was acquired by GE in 1986, almost 60 years later-how’s that for a sure thing?), or the electronics and computer revolution. Remember that technology benefits everyone. In fact, it often benefits the users more than the inventors and eventual industry winners—even if you can somehow identify them ahead of time. Besides, even if you are right about technology’s great future, are you the only one that knows this? If not, the market has already incorporated your great future into current prices (maybe that is why prices are very high now).

The only way to outperform the market is to exploit pricing mistakes by others. With investment professionals determining prices (they do about 90% of all dollar-weighted trading) do you really believe they have undervalued these stocks? The evidence is very clear that great earnings do not necessarily translate into great returns. Low-earning value companies have historically provided much higher investment returns (as compensation for their greater risk) than high-earning growth companies. 

New Paradigm: For five years now tech and large-cap growth stocks have led the way?

Been there, done that: It’s always obvious after the fact. Unfortunately, our before-the-fact crystal ball isn’t that clear. At the end of the 1970s the obvious asset classes to own were oil companies (6 of the 10 largest-cap stocks by market cap were oil companies), gold, other commodities, collectibles, and hard assets in general. These all proved to be very poor investments over the next 20 years. Sure, I wish I would have owned more technology over the past few years, but I didn’t have a crystal ball.

New Paradigm: But this is different. The U. S. clearly is the leader in technology. We dominate the Internet and biotech and financial services sectors.  That is where the future is. Besides, the U. S. free enterprise system has proven it’s the best model. Others have to now catch up.  

Been there, done that: At the end of 1989 Japan was at the top of the world. The Nikkei approached 40,000, having soared almost 500% for the decade (sound familiar). Their “managed economy” system was the envy of the world. Their model of giant interlocking companies was clearly superior to our model. Their technology was dominating ours. Tokyo was sure to become the financial center of the world. The Japanese had even bought up such important U.S. symbols as Rockefeller Center and the Pebble Beach Golf Course. Financial publications were saying, “you ain’t seen nothing yet.” We were reading such scary books as The Land of the Rising Sun. The U. S. was headed the way of the Roman and British Empires. With all that certainty, within three months the Nikkei fell 23%, finishing the year down almost 40%—and it kept falling. A decade later it is still over 50% below its peak of over 11 years ago. Sure thing?

New Paradigm: Just look at returns over the last few years. The opportunity is enormous. You can’t afford to miss out.

Been there, done that: What investors can’t afford is to be caught at the tail end of a bubble. When bubbles burst, they burst quickly, affording little opportunity to exit. Liquidity, which once seemed infinite, virtually dries up—buyers disappear and prices collapse. This is what happened to tulip bulbs, South Seas shares, in 1929, and may happen again. Investors in those bubbles where not making investment decisions based on traditional valuation methods. Instead, they were relying on faith and momentum—the ability to sell to somebody at a higher price. In fact, because market prices couldn’t be justified new metrics were invented to justify them. In the Japanese bubble’s case something called the Q-ratio was invented. Ever hear of the Q-ratio since?

New Paradigm: U. S. productivity is improving, growing at fastest rate.

Been there, done that: U. S. productivity is growing rapidly. However, it grew even faster in the 1920’s.

New Paradigm: The future for new age companies like AOL, Amazon, Cisco, etc., is so bright and obvious how can you possibly go wrong?

Been there, done that: First, the future is never perfectly clear. Second, even if the future turns out like you believe, that doesn’t guarantee great investment returns. Take the RCA example cited earlier. Every positive thing that was priced into RCA actually occurred. And some positive things that no one could have envisioned also occurred. For example, radio exploded as a medium, radio listenership increased for decades at a rapid pace, RCA remained a major player with a dominant market share, and new forms of entertainment specific to radio (example the soap opera) were created which brought in advertising money far in excess of what the newspapers generated. None the less, investing in RCA was a financial disaster. The “crystal ball” was clear, yet even still that was not enough to compensate for the “bubble” valuations.

Larry Swedroe: It is impossible without the benefit of a rearview mirror to tell whether a market or a sector is overvalued. In fact, the Efficient Markets Theory tells us that the market’s price is the one most likely to be the correct one. What we do know is that high valuations reflect great expectations. Great expectations mean low perception of risk. In turn, the result is low future expected returns. In addition, since we can’t determine if it’s a bubble, the winning investment strategy is to build a globally diversified portfolio that reflects your risk profile, financial objectives, and investment horizon. Then have the discipline to regularly rebalance; selling some of that supernova sector when it’s hot to buy something when that is currently relatively cheaper. Trying to guess whether a bubble is building (which you can take advantage of by jumping on the bandwagon) or about to burst (which you could take advantage of by shorting) is a loser’s game. It may be exciting, but it’s speculating, not investing.

Post Script

It’s important to remember that today’s Mag 7 is only the latest incarnation. Before that it was FANMAG and before that FAANG. Meta and Tesla got added after they had skyrocketed. And the original N was Netflix, not Nvidia. Again, the names were switched when one shot up and the other became less of a high flier.

While there are clearly some differences between today’s situation and that of the situation when I wrote the above article in January 2000, investors should not lose sight of the fact that historically, high valuations, such as those seen in today’s Mag 7, have historically led to disappointing returns. The following analysis of the performance of the 10 largest U.S. stocks in the periods after they joined that elite list provides empirical evidence of that fact. With data covering the period 1926-2023, in the 10, 5, and 3 years prior to doing so their per annum returns were 11.8%, 20.0%, and 27.2%, respectively. However, in the 3, 5, and 10 years post joining their per annum returns were 0.5%, -0.9%, and -1.5%, respectively. In other words, after their spectacular performance allowed them to become one of the 10 largest stocks, over the next three-, five-, and 10-year periods these once high flyers underperformed totally riskless one-month Treasury bills.   

The takeaway is that the historical record suggests that thinking “this time is different” is dangerous to your financial health.

Larry Swedroe is the author or co-author of 18 books on investing, including his latest, Enrich Your Future: The Keys to Successful Investing.

Go Source