The stock market is on a historic run, with U.S. stocks eclipsing $42 trillion in value for the first time ever last week. The broad market, measured by the S&P 500, continues a decade of strong returns with the rolling 10-year real return for the market above 10% (Chart A, below).

Chart A
S&P 500 Trailing 10yr Real Annualized Return

Market of Stocks

Many of this year’s “stay at home” themes are playing out and the technology sector is on a tear. Yet, this year reminds us it is not so much a “stock market” as a “market of stocks.” Even though the S&P 500 is up 17.1% year-to-date, consider the following:

  1. 8.5% percentage points of that return came from technology. Excluding that sector, the S&P 500 is up just 6.7%.
  2. Just ten stocks accounted for a full 12 percentage points of the 17% S&P 500 return.
  3. The median return of the 500 stocks in the S&P 500 is near 0%.
  4. And more than 200 of the 500 stocks in the S&P 500 are down for the year, with an average return of -20% in that group.

Beneath the surface, there is quite a lot going on here. At some point, value-oriented investors are likely to notice a growing gulf between a handful of highly-priced popular stocks and the rest of the market.

Lessons of the Past

It pays to remember lessons of the past. So let us look back twenty years when technology was also enjoying a bull run. At the start of the New Millenium, Microsoft was the most valuable company ever by market capitalization with a value of over $600 billion. The stock traded near 80 times earnings, with earnings growth of 40% per year posted throughout the 1990s. The future seemed bright, indeed.

A year later, in late 2000, General Electric (GE) grabbed the top perch as the most valuable company in America. GE was a venerable industrial juggernaut, and earnings had grown steadily by over 10% annually throughout the 1990s. The stock’s value reached 45 times earnings by 2000, a massive multiple for such a mature business. Yet investors who eagerly bought and held either stock began a long period of regret. Subsequent performance failed to meet and exceed the lofty expectations of the early 2000s. Microsoft investors endured a 50% decline (-4.5% annually) from 2000-2010, and General Electric investors suffered a 78% decline (-4.5% annually) from 2001 to today.

The lesson of the 2000 bear market was not the only one. During the 1960s, a group of companies called the “Nifty Fifty” saw a robust rise. These conglomerates were popular household names and had a similar story of uninterrupted growth. But the prolonged bear market of the 1970s caused valuations of the “Nifty Fifty” to fall to low levels along with the rest of the market, with most of these stocks under-performing the broader market averages. Unrealistic investor expectations and excessive starting valuations created the conditions that led to the sharp losses in these otherwise well-known household names.

Lesson 1: Be careful of high valuations, multiples meaningfully above 50 or 60 times earnings can reflect unrealistic expectations that are hard to achieve.

Lesson 2: When valuations stop making sense, breaking with the herd can sometimes pay big dividends.

The Big Picture: A Century of Valuations

In most times, valuations tend to have little near-term predictive power. A measure of long-run valuation that adjusts for cyclical swings in earnings is called the Cyclically Adjusted Price to Earnings, or CAPE, ratio (Chart B, below). This ratio was popularized and made available by Professor Robert Shiller of Yale. As you can see, the ratio has risen in recent years as stock prices ran ahead of normalized earnings. The bottom chart (Chart C, below) shows the relationship between CAPE valuation levels (vertical axis) and subsequent ten year real annualized returns (bottom axis). As you can see, there is a negative, albeit imperfect, relationship between valuation and return most of the time. Today’s above-average CAPE multiple of 33 suggests that future returns could be harder to come by, making prudent valuation and stock selection even more critical now than in the past.

Chart B
Cyclically Adjusted Price to Earnings Ratio (CAPE)

Chart C
CAPE and Subsequent Returns

Lessons for Today

This year’s wild ride drove investors toward thematic and growth-oriented firms. Emerging technology and high-growth companies became the popular answer for many traders during 2020. But now, we see several stocks with market values at or near $2 trillion, implying lofty expectations in some areas. Many of today’s high-growth darlings trade with earnings multiples well above 50 — a warning level of past trouble.

Even if earnings rebound next year and bond yields remain low, there are pockets of extreme valuations and aggregate market valuations appear full. Although trends remain positive for now, it makes sense to focus on balancing quality with value as we go forward from here. High starting valuations suggest that a more tactical posture and/or stock-picking skill will be required to outperform.

Kevin R. Caron, CFA
Senior Portfolio Manager

Chad Morganlander
Senior Portfolio Manager

Matthew Battipaglia
Portfolio Manager

Steve Lerit, CFA
Senior Risk Manager

Paul Clark, CFA
Senior Portfolio Manager
Municipal Fixed Income

Rick Marrone
Senior Portfolio Manager
Municipal Fixed Income

Suzanne Ashley
Internal Relationship Manager

Eric Needham
Director, External Sales and Marketing

Jeffrey Battipaglia
External Sales and Marketing


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