Major technology companies like Amazon, Apple, and Google have surged after the Covid-sparked market drop earlier this year. In fact, the stocks of these companies are now significantly higher than before the pandemic struck.
The S&P 500 index consists of roughly 500 major U.S. corporations and is thought to be a broad representation of the U.S. economy. But over the last several months, the largest five stocks in the S&P 500 have grown to account for nearly 25% of the overall market capitalization, leaving the remaining 495 stocks to make up the remaining 75% of the market’s value. (Similarly, these five stocks make up an eye-popping 38% of the Nasdaq Composite.) Do these five companies really represent 25% of this nation’s economic output? The answer is definitely no, and it’s not even close.
Indeed, the fly-in-the-ointment is that most stocks are still below—some well below—pre-covid levels. In other words, the market’s internal fundamentals are much weaker than the strength of just a few large tech companies and their outsized influence on the S&P 500 stock index. This is not a problem so long as these names continue to do well, but should these stocks fall out of favor, then they will have a similar outsized influence, but to the downside.
A Tale of Two Economies
The bifurcated picture of surging tech companies next to many other stocks that are struggling has been the same in the economy. Some areas like housing and retail sales have already bounced back above pre-pandemic levels, while restaurants, bars, gyms, yoga studios and other small businesses struggle to navigate reopening and hiring back employees.
As we move into the 4th quarter, and especially October (a notoriously painful month for stocks), there are three major issues that the stock market must contend with: uncertain economic growth due to the ongoing pandemic, over-valued stocks, and the election.
Priced for Perfection
The Shiller price-to-earnings ratio—a P/E ratio based on average inflation-adjusted earnings from the previous 10 years—currently sits at 33. It has only spent any considerable amount of time above a P/E ratio of 30 on three occasions: just prior to the Great Depression, just prior the bursting of the dot-com bubble, and just prior to the fourth-quarter swoon for equities in 2018. In other words, a Shiller P/E above 30 is usually bad news.
This valuation imbalance has not been lost on corporations and their stock buybacks. It is no secret that common stock repurchases have been a key driver of demand for equities over the past decade. But 2020 is likely to produce the lowest level of share buybacks in years. In addition, corporate dividends have been slashed or eliminated completely in sectors like energy, banks and airlines. Without these incentives for investors, demand for equities could slow considerably in the quarters that lie ahead.
Additionally, the forward earnings yield (a measure of expected corporate profit growth) has dropped to its lowest level on record—a sign investors are bidding up stock prices to an extent far greater than justified by forward earnings estimates. While earnings yields are still above bond yields, the relative valuation gap has been narrowing, as earnings yields have been falling faster than bond yields. And when adjusted for real GDP growth, the relative valuations no longer favor equities. The implication is that equities may not benefit from the low interest rates with economic growth declining, given the stretched valuations.
With valuations stretched, the stock market is more vulnerable to the headline risks associated with a struggling economy and a polarized election. We expect more of the same volatility we have had in September as we barrel towards the November 3rd election.