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Just as any propaganda needs a certain germ of truth to grow from, so do stock-market bubbles, beginning with six of the S&P 500’s SPX, -0.56% current darlings — Facebook FB, +1.20% , Amazon.com AMZN, +0.79% , Alphabet (Google) GOOGL, -0.66% , Netflix NFLX, +0.85% , Apple AAPL, -0.57% and, Microsoft MSFT, -0.59% — or collectively, FANGAM.
Each of the FANGAM stocks are investments in incredible companies (germ of truth), and they function better in this virus-infested world (another germ of truth). But at the core, their existence is grounded in the real, not virtual, world.
For instance, Google’s advertising business will continue to take market share from non-digital forms of advertisement, but on-the-ground companies are the largest source of the company’s advertising revenue. If the real world is not doing well, neither will Google. Also, the law of large numbers kicks in at some point: A company cannot grow at supernormal rates forever or it will become bigger than the market it is serving.
The so-called Nifty Fifty stocks come to mind here. These 50 stocks were the Who’s Who of Corporate America in the late 1960s and early 1970s: Coca-Cola KO, -2.06% , Walt Disney DIS, -3.39% , IBM IBM, -1.36% , Philip Morris MO, -1.88% , McDonald’s MCD, -1.54% , Procter & Gamble PG, -0.30% — the list goes on.
The world back then was their oyster. These were one-rule stocks — and that rule was to buy them at any price. They were great companies and how much you paid for them was irrelevant. Until it wasn’t.
Today’s “Nifty FANGAM” are not as expensive as the Nifty Fifty were in 1972. Investment adviser Lawrence Hamtil put together research that divides the Nifty Fifty stocks into two groups. The cheap basket traded at around 28 times earnings and the expensive basket at about 60 or so. Neither the cheap nor the expensive basket did well in the decade of the 1970s. Currently, Nifty FANGAM stocks trade closer to the cheap basket’s valuation.
If you bought and held Coca-Cola or McDonald’s (or any other Nifty Fifty stock) in 1972, you would have experienced a painful decade of no returns; in fact, at times you were down 50% or more. Coca-Cola was as great a company in 1974 as it was in 1972, but the stock was down 50% from its high. It wasn’t until the early 1980s before Nifty Fifty stockholders who bought at the top broke even.
Greatness and past growth are not enough
As a stock investor, I am struggling with several issues about markets today. For one, U.S. interest rates and inflation were much higher in the 1970s and early 1980s. Globalization has been deflationary, thus any move to de-globalization now will likely be inflationary — but automation may dampen the inflationary impact. If U.S. interest rates turn negative, then stocks’ price-to-earnings ratio should get a boost, except that negative rates indicate that corporate earnings are collapsing.
Another issue: If you held many of the Nifty Fifty stocks from 1972 to 1992, they would have delivered a decent (10%-plus) return. This sounds great in theory, but most investors would have lost patience after 10 years of zero- or negative return. Put another way, the shareholders who bought these stocks in 1972 were most likely not the ones who profited from them in 1992.
The Nifty FANGAM are one-rule stocks of today — people are buying them irrespective of price. In part this is rear-view mirror reasoning: If you did not own these stocks over the past decade, your portfolio suffered an enormous headwind against the market. But what the Nifty Fifty showed us — that a company’s greatness and past growth are not enough — is still true. Starting valuation — what you actually pay for a business — has always mattered and still does.
Dividends aside, stock returns over the long run are driven not just by earnings growth, but by price-to-earnings as well. If price-to-earnings is high, the return you receive from future earnings is chipped away. Investors will come to terms with this when these high-flying FANGAM stocks eventually drag the market down.
So, how does one invest in this overvalued market? Our strategy is spelled out in this fairly lengthy article.
Vitaliy Katsenelson is chief investment officer at Investment Management Associates in Denver, which owns shares of Alphabet and Facebook in client portfolios. He is the author of “The Little Book of Sideways Markets” (Wiley).
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