The Other 98% of the Stock Market

The world we live in is complex and sometimes hard to understand. The S&P 500 has risen by 20% this year, which might make one think the economy is doing well, but this is misleading. The S&P 500 is dominated by ten companies which account for 31% of its value. Most of these companies are at the forefront of the artificial intelligence race, which is driving a technological revolution. Of the top ten, only two companies are nontechnology-based, one of which is Berkshire Hathaway. Yet even Berkshire Hathaway has a huge stake in Apple ($173 billion), which has been a big tech winner and increased 47% so far this year. Don’t think that Berkshire’s large stake in Apple means that they are fully betting on technology. After all, they still have $157 billion in cash, which shows that Buffett is not entirely optimistic here. If you are not as impressed by the economy as the headlines lead you to believe, you have a good reason for that.

 

 

A better way to understand the broader state of the economy is to look at the equal-weight S&P 500 index (RSP), which gives the same importance to the rest of the 490 companies as the top ten. This way, you don’t overweigh the impact of the big tech firms, which only make up 2% of the whole index. In contrast to the S&P 500, RSP has only risen by 5% this year, showing a much less rosy picture. You might be tempted to invest all of your money in the top ten list, but before you do that, you should think about some factors that may change your mind.

 

 

For example, in 2020, the S&P 500 lost 18% while the RSP only dropped 11%. In 2021, the S&P 500 gained 28% and the RSP kept up, rising 29%. This shows that having a diversified portfolio with less tech has not hurt your returns by much in the recent past. However, a more worrisome factor is that the top 10 companies have a market value of $20 trillion which is 70% of GDP ($28 trillion). This raises several questions. First, how much more can these tech giants grow, given the simple law of large numbers? Consumers still have other needs and wants beyond technology, such as food, transportation, entertainment, and so on. Second, how will these tech leaders cope with the increasing competition from other companies that are also trying to leverage AI and join the gold rush? Every company that is remotely connected to AI wants a piece of the pie. Third, how will these tech behemoths deal with the potential regulatory challenges from antitrust laws that were designed to prevent economic monopolies? These laws were enacted 100 years ago to curb the power of the industrial titans of that era and will likely apply today as well.

 

 

History suggests that in the next decade, the names of the top ten list will change, and most likely quite dramatically. We live in a very competitive world and nowhere is it more competitive than technology. The barriers to entry are low, sometimes only requiring someone’s garage or basement. Valuations of the current top ten are steep, which is natural when everyone wants to own the same thing and has a fear of missing out. The price-to-earnings ratios of Microsoft, Apple, Amazon, and Nvidia are extremely expensive, at 36x, 31x, 76x, and 115x respectively. The P/E of the S&P 500 is 25x and that is mainly due to the heavy weighting of the top ten. This means that investors are willing to pay much more for our top ten list than other companies in the S&P 500. Investors willing to pay a substantial premium are expecting some phenomenal growth in the next several years. Are these companies’ revenue going to become half of the U.S. economy? Will regulators let them? Finally, are the top ten immune to the effects of the wider economy?

 

 

It is estimated that our total Federal debt will reach 150% of GDP by 2032. That is up from our current level of 100% of GDP. Current federal deficits continue to run at over 5% of annual GDP. It is common sense that these numbers are not sustainable, and at some point, we will have to deal with them. The annual interest cost of the national debt is already starting to become a drag on the annual budget for the U.S., and the only way you pay down debt is to slow growth. You either raise taxes, lower spending, or a combination of both. The good news is that it is possible for artificial intelligence to help create a more efficient and productive economy. This is the third way our national debt becomes more manageable. The problem is that politicians have shown no restraint when they see a few extra dollars become available to spend.

 

 

The last month has shown us with the rapid rise in the market that you cannot time the economy or the market. The U.S. debt rating is about to be cut below AAA by all the rating agencies due to our rising debt situation, however, the market climbs higher. Commercial office buildings are suffering a major recession, while residential properties climb higher. Higher interest rates have had an impact on the economy but not uniformly, which goes back to the beginning of this letter that suggests the world does not make sense. Of course, it never makes total sense, the economy is extremely complicated. There are always opportunities and they are usually somewhere other than where everyone is looking. In 2022 when big tech experienced a significant decline, many value and dividend-oriented companies had a positive year. That doesn’t mean they were better companies, investors just decided they were better investments at that moment. Price is what you pay, value is what you get.

 

Observations On The Market No.389