Is it a bubble or isn’t it? That’s what everyone seems to be asking about the US stock market. I say it isn’t. A bubble to me is when price becomes disconnected from any rational, articulable value, the way people chased opaque schemes in the Roaring 1920s or the blind faith in new internet companies in the 1990s.
This is not that. This market is driven by some of the most innovative, impactful and profitable businesses the world has ever produced. Yes, investors are paying a bigger premium than usual — more than I want to pay — at about 22 times forward earnings for the S&P 500 Index. But the valuation is not unreasonable for such a high-quality market and well below what we saw in the late 1990s or even as recently as 2020.
That doesn’t fully answer the question, though. When investors worry about bubbles, they’re also asking if the market’s meteoric rise is sustainable. Possibly. But the burden of generating growth in the years ahead falls to a narrowing set of index heavy weights, leaving less room for error. If these high performing, mostly artificial intelligence-related, companies fall short of investors’ grand expectations, the market will slow or even pull back.
The likelihood all comes down to earnings growth — that single variable has accounted for more than 70% of the S&P 500’s total return since the 1990s, with the rest attributable to dividends and changes in valuation. To assess the outlook for earnings growth, it helps to look one layer deeper at its main drivers, namely revenue and profit margin.
While revenue growth and profit margin expansion contributed about equally to earnings growth during the past four decades, further margin expansion is questionable. This for the S&P 500 has soared to 15% from 4% in the early 1990s as higher-margin technology and services companies replaced lower-margin manufacturers.
For margins to expand further, artificial intelligence will have to meaningfully boost productivity for S&P 500 companies without kneecapping pricing power, or high-margin companies will have to gain further market share. Arguing against it is the tendency of profitability to mean revert; much higher margins for the broad market would be unprecedented.
So investors can’t count on further margin expansion, leaving revenue growth to do the lifting. The road is narrowing here.
The number of companies contributing to S&P 500 revenue growth is expected to shrink significantly in the coming years, putting investors’ hopes for continued growth on a small cadre of companies. Just 13 are projected to produce half of the S&P 500’s revenue growth over the next four years, less than half the number involved in the five years previous, according to estimates compiled by Bloomberg.
Index gains going forward will rely heavily on the performance of the Magnificent Seven (minus Tesla Inc.); AI darlings Broadcom Inc., Micron Technology Inc., Oracle Corp. and Dell Technologies Inc.; and, somewhat surprisingly, Ford Motor Co., Walmart Inc. and McKesson Corp.
Broaden the analysis to 80% of the S&P 500’s revenue growth, and the number of companies contributing shrinks from 104 over the previous five years to just 70 in the next four.
This latter group accounts for nearly two-thirds of the market-capitalization-weighted S&P 500, meaning most index companies could perform spectacularly in the years ahead and barely move the gauge.
Concentration has already hurt the market this year, perhaps an early sign that investors are having second thoughts about betting on too few companies. The S&P 500 is up 13% through Tuesday excluding the Magnificent Seven, 3 percentage points better than the full index. The Magnificent Seven, meanwhile, has eked out only a 3% gain.
There are certainly stocks that look bubbly. Tesla Inc. trades at 176 times forward earnings, and 12 others trade at more than 70 times. But together they represent less than 5% of the index, so there isn’t much riding on them.
The problem with the S&P 500 isn’t that it’s terrifyingly overvalued. It’s that continued growth is in the hands of a shrinking number of companies. If they disappoint, the market’s high-flying days are over.
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