We’re finally in bull market territory. And that’s healthy, right?
Many bearish market watchers say it’s not.
As you likely know, the start of a bull market is typically marked when stocks rise 20% off their recent low.
The S&P 500 hit that level on June 8… and the Nasdaq Composite a month earlier.
So what’s the problem?
I’ve seen two primary complaints about this bull market…
Complaint No. 1: Top-Heavy
The first holds that this market rally is far too concentrated in a handful of mega-tech stocks. And in fact, I wrote about this phenomenon myself two months ago.
The best way to illustrate that concentration is with this visualization, provided by Finviz, of the one-year performance of S&P 500 companies.
Each rectangle in the image is a company in the index, and the size of the rectangle represents the company’s market capitalization.
The colors of the blocks in the graphic – which range from bright red to gray to bright green – represent performance. Here’s the key…
As you can see, the largest companies in the index have posted the biggest gains over the last 12 months. By a long shot.
The S&P 500 is weighted by market capitalization, meaning that a company’s valuation determines how much it can move the index. Bigger companies will move it more, both up and down.
So when a $3 trillion company like Apple (Nasdaq: AAPL) gains 45% over 12 months, it’s going to pull the index up quite a lot.
In fact, artificial intelligence chipmaker Nvidia (Nasdaq: NVDA), which is up 190% over the past year, contributed about a quarter of the S&P 500’s gains over that time.
The detractors of this bull market say that’s just too much concentration. They complain that it’s misleading as to what the broader market is doing. And you can’t expect a bull market led by just a few companies to have legs.
Complaint No. 2: Too Expensive!
The second complaint these bears have is that stocks are just too expensive right now, particularly relative to the rest of the world. And the elevated valuations of U.S. stocks mean they probably won’t get the typical earnings season bounce this year… even if earnings exceed expectations.
Now, the part about U.S. stocks being relatively expensive is certainly true.
According to Yardeni Research, the forward price-to-earnings (P/E) ratio for U.S. stocks is 19.4. Meanwhile, EAFE (Europe, Australasia and the Far East) stocks are trading at 13 times forward earnings and emerging market stocks are trading at just 12.2 times forward earnings.
U.S. stocks are also expensive by historical standards.
The Shiller P/E ratio, which is based on average inflation-adjusted earnings from the previous 10 years, stands at almost 31 right now. That is far above the historical average – and right around where it was on Black Tuesday in 1929 when Wall Street crashed and pulled the world economy down with it.
So I see where the bears are going here. But I still push back against both complaints.
First, just because the current market rally is being fueled primarily by a few heavyweight stocks – with serious momentum – doesn’t mean it can’t continue.
Goldman Sachs’ research division looked closely at historical rallies that resemble the current one (led by a few stocks). It found that such narrowly led markets did not result in poor returns for the broader market over the following year. In fact, participation in market rallies has tended to broaden from those few leaders to the rest of the market.
That’s a good sign for stocks going forward.
Oh, and for what it’s worth, the greatest living investor doesn’t seem to worry about investing in the biggest momentum stocks…
As of last month, the largest position in Warren Buffett’s Berkshire Hathaway (NYSE: BRK-A) portfolio was Apple. The world’s largest company accounts for almost 47% of Berkshire’s holdings. The next-largest holding, Coca-Cola (NYSE: KO), accounts for just 6.4%. (Check out Buffett’s current portfolio here.)
Second, though stocks are certainly expensive right now, that doesn’t rule out further gains over the next year.
Research from Charles Schwab found that there is a very weak relationship between the P/E ratio of the S&P 500 and its performance one year later. Indeed, the brokerage’s research identified instances when a sky-high forward P/E ratio of 25 was followed by precipitous drops in the market and instances when it was followed by enormous gains.
It’s better to focus on earnings than valuations. And FactSet says analysts expect S&P 500 earnings to grow slightly in the third quarter – about 0.3% – and roar ahead almost 8% in the fourth quarter. That would mark the best quarterly performance in almost two years.
As we know, stock prices inevitably follow earnings.
So is this rally too narrow and are stocks too expensive? Get out of the market if you believe that’s true. As for Alexander Green and me? We’re staying in the market.