Why the S&P 500’s five-year prospects are poor

Today’s Conventional Wisdom

“At times,” reckons Richard Saintvilus (“Trusting the Magnificent Seven Stocks,” Nasdaq.com, 14 November 2023), “it can be a struggle to believe in the overall direction of the stock market, particularly as uncertainty remains with regards to interest rates and anticipating the Federal Reserve’s next policy decision. But when it comes to the ‘Magnificent Seven’ stocks, so named by Bank of America analyst Michael Hartnett, there are plenty of the reasons to remain optimistic.”

Earlier this year, Hartnett used this phrase to refer collectively to Alphabet (the parent of Google), Amazon, Apple, Meta Platforms, Microsoft, Nvidia and Tesla. “These mega-cap tech giants, which are largely focused on secular growth trends such as artificial intelligence, cloud computing, and cutting-edge hardware and software, have powered the broad (sic) market rally we have seen.”

“However,” he cautions, “given that these seven mega-caps account for a massive (percentage of the S&P 500 Index), an argument can be made as to whether the rally is as ‘broad’ as it is believed to be. As of (10 November), the Index is up nearly 15% year to date. However, without the cap weighting of the Magnificent Seven, the S&P 500 would be in negative territory for the year. This speaks to how heavily concentrated this trade currently is.”

Nonetheless, Saintvilus concludes, “with their exposure to high-growth technologies, such as high-end software and hardware, cloud computing and artificial intelligence, (these) seven stocks have more than doubled the return of the S&P 500 over the past decade. Armed with tons of cash on their balance sheets, strong cash flows and excellent leadership, the Magnificent Seven are well-positioned to continue leading their respective markets over time … In other words, even as the Magnificent Seven stocks are at a combined market capitalization of (almost $12 trillion, equivalent to the GDPs of Germany, Japan and Britain), there are still many reasons to expect them to continue to rise over time.”

My Assessment: An Overview

Saintvilus, like most bulls, slights and ignores historical evidence. The bulls must act myopically: if they gave the past its due, they’d have to temper – and perhaps recant – their present enthusiasm about the future. 

Investment is a process of accurately identifying and acting sensibly in response to odds. These odds derive from past experience, and in this article I demonstrate that they’re now unattractive: given some conservative assumptions, it’s reasonable to expect – or, at least, take seriously the possibility – that over the next five years the S&P 500 Index, including the Magnificent Seven, will incur hefty losses.

The S&P 500’s “Magnificent Seven” versus the Rest

“Big tech stocks reclaimed their position as the market’s leaders (in 2023),” wrote Hardika Singh (“It’s the Magnificent Seven’s Market. The Other Stocks are Just Living in It.” The Wall Street Journal, 17 December). “Collectively,” she continues, “the stocks known as the Magnificent Seven … have jumped 75% …, leaving the other 493 companies in the S&P 500 in their dust. (Those have risen a more modest 12%, while the Index as a whole is up 23%.)”

That’s a dramatic – indeed, diametric – change from 2022: during that year the Magnificent Seven plummeted 40%, losing $4.7 trillion of market capitalization (an amount greater than Germany’s GDP), whereas the S&P 500’s remaining 493 stocks dropped 12%.

Most investors, Singh recounted, expected more of the same in 2023; instead, big tech launched “a furious rally that overcame a banking sector crisis, worries about a government debt default and wars in the Middle East and Europe.” It behooves investor to expect – or at least consider – the unexpected.

During the year to 20 December, Microsoft’s shares rallied 56%, and in late-November scaled all-time record highs. Apple added 52% and in June became the first American company whose market cap eclipsed $US3 trillion. Above all, Nvidia shares have more than tripled and its market cap soared above $US1 trillion. Yet other tera-techs still haven’t recovered from last year’s beating: most notably, Amazon, Alphabet, Meta and Tesla continue to trade below the heights they scaled at the end of 2021.

Figure 1 puts these recent developments into long-term context. It plots the total CPI-adjusted returns (capital growth plus dividends, expressed as five-year compound annual growth rates (CAGRs)) of the top seven and bottom 493 (measured by market cap) companies in the Standard & Poor’s 500 Index. From December 1979 to December 1984, the CAGR of the Index’s bottom-493 was 9.0%; from January 1980 to January 1985, it was 9.6%, etc.

Figure 1: Two Variants of the S&P 500 Index, Five-Year CPI-Adjusted CAGRs, Monthly Observations, December 1984-September 2023

Four key results emerge from Figure 1. First, the over almost 40 years the top-seven companies’ five-year CAGR has averaged 9.4% and the bottom-493 companies’ 8.7%; accordingly, the top-seven have slightly outperformed (by an average of 0.75% per year). Equally, the top-seven’s CPI-adjusted, five-year CAGR is slightly more variable than the others’ (standard deviation of 8.8% versus 7.9%).

Second, the two series show important trends over time. Before the Dot Com Bubble, and particularly during the 1980s, the bottom 493 companies mostly matched or outperformed the top seven; during the Bubble, the top seven greatly exceeded the others; from the trough of the Dot Com Bust until 2017, the two series closely tracked one other; and since 2017 the top seven have significantly outperformed the bottom 493 (by an average of 8.9% and by 10-20% from mid-2020 to mid-2022).

Thirdly, since the beginning of the century both series’ CAGRs have generally trended upwards. However, the top-seven’s trend is relatively consistent and strong, whereas the bottom-493’s is comparatively erratic and weak; indeed, over the past decade the bottom-493’s CAGR has decelerated. As a result, in the five years to September 2023, the top-seven companies’ CAGR is 9.6% versus the bottom 493’s 4.9%.

Finally, the top seven have greatly outperformed the bottom 493 during two periods: the Dot Com Bubble and since 2017. Figure 2, which plots the differential of the two series, clearly depicts this result: since 2017, the top-seven’s outperformance of the bottom-493 has been as marked and as extended as it was during the Dot Com Bubble.

Figure 2: Five-Year CAGR, S&P 50’s Top-7 Net of Its Lower-493, Monthly Observations, December 1984-September 2023

The “Magnificent Seven” – Today and Yesterday

Using monthly data compiled by FactSet, Figure 3 plots the combined share of the S&P 500 Index of its largest seven (by market cap) companies.

On average since December 1979, their combined market cap has comprised 17.5% (standard deviation of 3.5%) of the Index. Recently, however, they’ve bulked much larger: since March 2020, their combined marked cap has averaged 26.0% of the Index; and since May 2023 it’s averaged 28.2%.

Figure 3: Combined Share of the S&P 500 Index’s Largest Seven (by Market Cap) Companies, Monthly Observations, December 1979-September 2023

Since March 2020, these companies’ share of the S&P 500 has exceeded its long-term average by 2.4 standard deviations or more. As a result, the Index has been more unbalanced – that is, top-heavy – than at any time, including the Dot Com Bubble, since the late-1970s.

This is “mind-blowing to me when I think about an index that’s supposed to represent such a broad group of companies,” said a funds manager whom Singh cited. “The influence of (these) big tech stocks is massive on a global scale, too,” she added. “Within the MSCI All Country World Index – a benchmark that claims to cover about 85% of the global investible equity market – the combined weighting of the Magnificent Seven is larger than that of all of the stocks from Japan, France, China and the U.K.”

Today the S&P 500 isn’t merely extremely top-heavy: as Table 1 shows, over the past 40 years it’s also become extremely tech-heavy.

Table 1: S&P 500 Index’s Top-Seven (by Market Cap) Companies since 1980

Table 1 lists the S&P 500’s seven-largest companies at five-yearly intervals since 1980. In that year it was very petroleum-heavy: five of its seven biggest components were producers of (or, like Schlumberger, servicers of producers of) oil and gas. In 1911, Congress forced the breakup of Standard Oil (“Esso”) into several regional components; the largest, Standard Oil of New Jersey, long remained by far the S&P 500’s biggest company; its current successor, ExxonMobil, was as recently as 2010 the Index’s biggest company (Standard Oil of New York was Mobil’s principal ancestor). BP acquired Amoco, whose official name was Standard Oil of Indiana, in 1998; in 2001, Standard Oil of California became ChevronTexaco Corp.

In 1980, only one of the S&P 500’s top-seven companies, IBM, could be considered as a “tech” – and even at the apex of the Dot Com Bubble in 2000, only two could so be regarded. By 1985, the number of energy producers in the S&P 500’s top seven had shrunk to two; until 2010, there was just one; since then, there have been none.

In diametric contrast, the number of “tech” companies has grown steadily – such that ALL of today’s top seven (the Magnificent Seven) are regarded as “techs.”

Today’s Extremes and Tomorrow’s Returns

In two crucial respects, today’s S&P 500 has reached extremes: never before has it been as top-heavy – or as tech-heavy – as it is now.

According to Singh, “investors and strategists have long raised concerns about market concentration. When just a handful of stocks are responsible for most of the market’s gains (as was the case in 2023), it becomes more vulnerable to a downturn if a few heavyweights fall.”

My analysis of historical data corroborates their concerns. For each rolling five-year period since December 1984, I (1) calculated the S&P 7’s and the S&P 493’s total, CPI-adjusted return (expressed as a five-year CAGR), (2) ranked these data according to the top-seven companies’ combined share of the S&P 500’s total market cap, (3) stratified the data into quintiles (five groups of approximately equal numbers of observations) and (4) calculated the S&P 7’s and S&P 493’s average CPI-adjusted total five-year CAGR within each quintile.

Table 2 summarises the results – three of which are most important. First, the combined share of the S&P 500’s top-seven companies during a given month regresses towards its overall mean (17.5%) during the next five-year period.

In other words, the lower the combined share falls in a given period (average of 14.1% in Quintile #1), the more it rises (average of 17.9%) during the subsequent five-year period. And the higher it rises in a given period (average of 22.8% in Quintile #5) the more it falls (average of 17.5%) in the subsequent five-year period.  

Table 2: Stocks’ Total Returns (Five-Year, CPI-Adjusted CAGRs), by Combined Share of the S&P 500 Index's Largest Seven Companies, December 1984-January 2023

As we saw in Figure 3, since 2017 the top seven’s combined share of the S&P 500 Index has zoomed above 25%. That level is within the highest quintile (#5) in Table 2. If past is prologue, then during the next five years the top-seven companies’ combined share will subside towards and perhaps to its overall mean. What will be the consequences for stocks’ returns?

The second result in Table 2 puts recent history into longer-term context: an increase of the combined share of the S&P 7 is a co-incident indicator of its higher total return – but of the S&P 493’s lower total return. 

An increase of the S&P 500’s top-heaviness increases its top-seven companies’ CAGRs – but crimps its lower-493 companies’ returns. What we’ve observed during the past 5-10 years is a specific instance of what’s generally occurred since the 1980s.

Thirdly, an increase of the top-seven’s combined share of the S&P 500 is a leading indicator of the top-seven’s lower total return – but of the lower-493’s higher total return.

In other words, an increase of the S&P 500's top-heaviness during the preceding five years foretells (1) a decrease of the top-seven's CAGRs and (2) an increase of the lower-493 companies' total returns during the next five years. On this basis, during the next five years we can therefore expect the bottom-493’s CAGR to increase in absolute terms – and also relative to the top-seven’s .

Thus far I’ve omitted stocks’ valuation from the analysis, but it’s crucial that I incorporate it. According to Singh, “tech stocks still look expensive compared with the broader market. Nvidia is trading at 25 times its projected earnings over the next 12 months, while Microsoft’s multiple is 31 and Apple’s is 30. In comparison, the S&P 500 trades at 19 times future earnings.” She also cited a funds manager who asserted that it’s fine paying high earnings multiples for tech stocks because they can outperform during periods of higher interest rates: “everybody comes back to valuations, ‘Oh, but they’re so expensive.’ But they’re not. In a slowing economic environment, you want to be invested in reliable growers. These are the kind of companies that deliver.”

That’s demonstrably false. I (1) took the observations in the highest quintile (#5) of Table 2, (2) sorted them according to their cyclically-adjusted PE ratio (CAPE) and (3) computed the various results in Table 3. Three are paramount.

Table 3: Stocks’ CPI-Adjusted Total Returns, Highest Quintile of Combined Share, Stratified by CAPE, 1984-2023

First, the observations in the top quintile of Table 2 boast high CAPEs. The higher is the combined share of the S&P 500’s seven largest companies, the higher is the Index’s CAPE. Top-heaviness, in other words, begets high valuations and vice versa.

The problem for enthusiasts of the Magnificent Seven isn’t just that CAPE regresses to its long-term mean: because the Index’s CAPE and its top-heaviness are positively correlated, the impact upon returns of a decrease of top-heaviness is particularly severe when CAPE is high.

A decrease of the top-seven’s share of the S&P 500 doesn’t merely beget much lower returns (Table 3): when CAPE is high, as it currently is (within quintile #4 of Table 3), decreases of top-heaviness beget losses.

These losses are appreciable: during the next five years, the Index’s top-seven companies’ CAGR of -2.8% implies a total loss of (1 – 0.028)^5 = -13%; the Index’s bottom-493 companies CAGR of -4.1% implies a total loss of (1 – 0.041)^5 = -19%. In relative terms, the Magnificent Seven will outperform the Index; but in absolute terms, both generate losses.

Implications

It’s amusing but telling: enthusiasts of today’s Magnificent Seven are oblivious to – or, if they’re aware of it, omit to mention – the fact that The Magnificent Seven is an American movie released in 1960. Its screenplay was a remake – Old West-style – of a 1954 Japanese film Seven Samurai; a remake of the remake appeared in 2016.

The film’s title derives from its plot. A gang of bandits periodically plunders an impoverished Mexican village. After the latest raid, its leaders resolve to resist. Three of them ride to a town just inside the U.S. border in order to acquire weapons. They ask Chris, a veteran gunslinger, for advice. He suggests that they hire mercenaries to defend the village. At first he agrees only to help the villagers recruit the posse, but eventually decides to lead it. Despite the meagre pay and high risks, he attracts six others to the cause.

Although the seven defeat the marauders, the village suffers greatly – and only three of the posse live to see their victory. At the movie’s end, Chris bids farewell to an elder who tells him that only the villagers have won; the gunslingers, in contrast, are “like the wind, blowing over the land and passing on.” As he passes the graves of his fallen comrades, Chris admits to himself that “the Old Man was right. Only the farmers won. We lost. We’ll always lose.”

A majority of the posse in The Magnificent Seven, in other words, didn’t survive. From their point of view, those are hardly attractive odds!

Asked how he became such a successful investor, Warren Buffet once said it was a matter of accurately identifying and acting sensibly in response to odds: “take the probability of loss times the amount of possible loss from the probability of gain times the amount of possible gain. It’s imperfect but that is what (investment is) all about.” Successful investors avoid long odds and embrace short odds.

That’s why Leithner & Company searches for extremes in markets: we seek short odds (companies which, according to our conservative assumptions, are sound but others shun) and reject long odds (very popular and thus highly overvalued securities). Over almost a quarter-century our comprehensive analysis and research, and the framework which underlies them, have given us an edge (see our web site for details). When you possess a logically valid and empirically reliable theory, then, to paraphrase James Grant, you stumble less in the dark. “You can begin to visualise in the dark, which is where we all work.”

“The future,” adds Grant, “is always unlit. But with a body of theory, you can anticipate where the structures might lie. It allows you to step out of the way every once in a while.”

If key aspects of financial markets regress to their long-term means, then today’s extremes are transitory. Yet today’s enthusiasts of American stocks – and particularly of the Magnificent Seven – don’t assume (as contrarians do) that the present is transitory.

Hence bulls don’t wish to step aside; instead, they assume that today will continue into the indefinite future, and are thus keen to charge full steam ahead. They’re seemingly blithely unaware of the unappealing longer-term odds they face.

Goldman Sachs is typical of the stampeding herd during a bull market. On 17 December it lifted its target for the S&P 500 by 8% (to 5,100 by the end of 2024). It foresees tailwinds from falling consumer price inflation and declining interest rates. Of course, they could be correct. But in order to be right they must tacitly (they can’t do it explicitly – that’d expose the weakness and riskiness of their position) assume that today’s extremes won’t merely persist: they’ll become even more extreme.

Like most boosters, Goldman ignores or rejects the possibility – I’d call it a probability – that today’s extremes regress to their long-term means. If they do, then the S&P 500 won’t just become less top-heavy; its valuation will also fall from its present elevated level. In short, the Index – including the Magnificent Seven – will generate losses.

Mellody Hobson and John W. Rogers, Jr. (“What the Stock Market Taught Us This Year: Don’t Fall for These Investing Traps,” The Wall Street Journal, 18 December) agree:

“Some now consider (the Magnificent Seven) to be defensive businesses that can grow through any economic cycle. We’ve seen this before, and the lesson is always the same: winner-takes-all can dominate over shorter time frames but is rarely a winning bet in the long run. At some point, this narrow market supremacy will end … In other words, these hyped celebrity stocks have more downside than upside from here.”

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