5,000 is Just a Number (Hopefully Maybe)

The S&P 500 (which basically tracks the stock performance of the largest 500 companies in the US) closed above 5,000 for the first time ever on Friday. From the amount of financial commentary that this number has produced, you would think we had landed on the moon AGAIN.

A couple of things:

They say age is just a number and I like that philosophy, inasmuch as mind over matter is a real force for humans. But for stock indices, the level really-really is just a number. I mean, if the good people at S&P Dow Jones got together on Wednesday and felt creative, they could just announce that the index was multiplied by 100, and all of a sudden, the S&P 500 would be at 500,000. It would a fun thing to do on a Wednesday, but it would be meaningless.

The reason this is an actual conversation to have, as opposed to a meaningless number to carry in your head is what it means for “valuations” (the price you pay for stocks relative to their business results) and for “animal spirits” (how sober or over-the-top the investing class is feeling these days). You see:

• The S&P 500 is up 20% roughly over the last 3 months. To keep it simple, if you did that 4 times in a row (which is the number of quarters in a year), you would be up more than 80% in a year. That’s not a thing that happens in normal markets.

• NVDA is up 45% in one month. NVDA is now the fourth largest stock in the S&P, at 4% of the index (so that if you own $100 of the S&P 500 basket, four of your buckaroos are in this stock). They make advanced computer chips. This is a big deal in the era of AI, almost like Cisco was a big deal when the internet first hit the scene (Spoiler: Cisco turned out to be a great business, not necessarily a great stock for a while there). But now, all the shares in NVDA are worth collectively $1.8T, which is a lot. In fact NVDA just surpassed Amazon. That’s after growing in value according to its stock price by about $600B this past January alone. Now that’s a lot! It’s roughly the amount by which the US economy grew last year (GDP growth) and it’s slightly more than all of JP Morgan is worth as a company to its shareholders. So… NVDA stock grew by (i) a whole JPMorgan last month or (ii) a whole US 2023 economy increment, depending how you like to think about those things. By the way, we’re not picking on NVDA. They are unequivocally at the center of a technological revolution, but as my former colleagues at Research Affiliates are asking here: are the prices right? And if you think NVDA is a little tame for your taste, ARM is showing moves that test your credulity even more. Long way around the block to say that “animal spirits” might be a little out of control...

How Expensive are US Stocks?

Perhaps the more significant question for investors with a long-run mindset is what this all means for valuations and future return expectations. The price you pay for an asset has an inverse impact on future return prospects. When you pay a high price for an asset, you can expect lower returns (“all else equal,” as they say). On the other hand, lower prices tend to position you for higher returns in the future. The “price” we’re talking about is relative to the earnings of a business, or relative to the earnings all of the companies in the investment basket when we’re talking about an index.

This is how you get a P/E ratio (for “price to earnings” ratio). The orange line below is the P/E ratio for the S&P 500 relative to the last 10 years of earnings (adjusted for inflation). When the orange line is high, stocks are expensive relative to history. When the orange line is low, stocks are cheap. If that’s too confusing, reverse the logic and focus on the dividend yield (the blue line). When stocks have high dividend yields, it means they pay a lot in distributions for a dollar of investment. That’s “cheap.” This is why blue and orange are basically mirror images of each other. The punchline is that US stocks (the largest companies anyway) are expensive. Not the most expensive ever (that’s the Tech Bubble of the late 1990s in the modern era) but expensive. They got the most cheap ever was in 2008-2009, which was a generational opportunity to buy leading US companies at bargain basement prices. But today, not cheap. Not even a little.

US Stocks: Forward-Looking Maybe, Backward-Funded Definitely

So, in a world where some stocks seem to be running well ahead of themselves with animal spirits and more generally, large US stocks seem expensive, there is a lot of “should” energy out there, about what markets should look like and why they aren’t conforming to these notions of “should.” Big words are being thrown around like “Marxist.” Maybe the stock market has been taken over by Marxists. I’m not kidding. People are saying this. The good news about that is that the stock market is way too noisy to put the Marxists at Vanguard on trial, as Brad Cornell reminded us recently.

The real issue is what is causing this and what might break it. This is where we have sympathy for the non-silly version of the argument that markets are distorted, but no more broken than usual, just more visibly so. And yes, it has something to do with the fact that passive investing (starting with buying the S&P 500 basket) is “price insensitive,” if not outright burn-down-the-system revolutionary.

Simply put, when you buy the S&P 500, you accept that the fraction of NVDA in the index is “fine, a-okay, not worth having opinions about.” That’s a decent self-aware baseline view, since most people aren’t equipped to have actual informed opinions on such things. The issue is that some people who fall in that bucket do have opinions and might be overeager to buy this or that. And when these people reach critical mass, prices get distorted. And that’s where the index issue comes in. Once prices are meaningfully off kilter, there is a whole machine that keeps throwing gasoline on the fire, twice a month like clockwork: contributions into 401(k) plans allocated to big passive funds, mostly US companies in the S&P 500. And the distortion can get even more … well … distorted. This is what we mean when we say “forward-looking and backward-funded.” As my former boss Rob Arnott reminded us often, This Too Shall Pass. My guess is, this will pass when the gasoline gusher is turned off for a while. In other words, when people start losing jobs and when 401(k) contributions shrink, the market will be forced to reassess whether all these prices are stable enough to stand on their own two feet. Another way to say it is, when YOLO (You Only Live Once) is replaced with PAYME (Pay All Your Monthly Expenses) as the zeitgeist.