War in the Middle East. War in Ukraine. Rising oil prices. Inflation still hovering above 3 percent, and mortgage rates above 6 percent. The possible reelection of Donald Trump, with the prospect of a trade war with China to follow. Investors in the stock market seemingly have plenty to worry about. But so far this year, they have shrugged off anxiety: The S&P 500 index had its best first-quarter performance since 2019, up more than 10 percent. And that’s on the heels of a strong 2023, when the S&P rose 24 percent.
Not surprisingly, this bull run has some market observers fretting. Jeremy Grantham—a perma-bear who seems never to have met a market rally he did not distrust—has warned that the market is at “illogical and dangerous” levels. Because a good chunk of the recent boom has been driven by tech stocks, particularly AI-connected stocks, some commentators have drawn parallels to the stock-market bubble of the late 1990s, dubbed the dot-com boom. Even the more restrained critics have argued that because the S&P’s performance has been driven by big gains in a relatively small number of highly valued stocks, the market is at risk of tumbling if those stocks hit a speed bump. As an investment strategist at J.P. Morgan put it recently, extreme market concentration presents “a clear and present risk to equity markets in 2024.”
The skepticism about the sustainability of this rally is unsurprising, given how much stocks have risen in just the past six months. And predictions about bubbles bursting are exciting and headline-grabbing. Understandably, too, when the stock market surges based seemingly on the good fortune of a few high-profile stocks, a lot of people get very nervous. But sometimes, stocks surge for a reason. The trick is to separate the signal from the noise.
The underlying reality is that this rally has been driven mainly by economic fundamentals, including the continued strength of the U.S. economy and corporate profit margins and profit growth, as well as some optimism about future interest-rate cuts by the Federal Reserve. Investors certainly have a good deal of uncertainty to wrestle with, but using the word bubble to describe this market is just a misnomer.
Take the concentration issue. True, much of the market’s gains last year were driven by the so-called Magnificent Seven stocks: Apple, Microsoft, Meta, Amazon, Alphabet, Nvidia, and Tesla. And, depending on what standard you use, the concentration at the top of the market is high by historical standards. (The collective market capitalization of the leading 10 companies in the S&P 500, for instance, accounts for about a third of the total value of the index.) Compared with other major stock markets, however, America’s is actually now less top-heavy than that of every country but Japan. In addition, concentration is more the norm than the exception in bull runs, as Ben Snider, a senior strategist at Goldman Sachs Research, noted in a recent report. Although a couple of those rallies—1973 and 2000—ended very badly, most did not.
The concentration in the market also reflects the concentration in the U.S. economy, which, particularly in the tech industry, is more and more a winner-take-most competition, in which the dominant players can earn enormously outsize profits and enjoy very high returns on invested capital. The chip maker Nvidia, for example, controls more than 95 percent of the market for specialized AI chips, which helps explain why it earned $33 billion in operating profit in its most recent fiscal year, up 681 percent from the year before. Likewise, Alphabet, Meta, and Amazon together vacuum up more than two-thirds of global digital-ad spending.
These companies’ hefty valuations reflect, in other words, their hefty profits, as well as their continued prospects for earnings growth. Again, look at Nvidia. Its stock is up a remarkable 214 percent over the past year. But during that same period, its forward price-to-earnings ratio (a simple measure of valuation) has actually fallen, because its earnings growth has outpaced the increase in its stock price. Snider calculates that the S&P 500’s top-10 stocks have a combined forward price-to-earnings ratio of about 25. That’s relatively expensive but hardly in bubble territory. As Snider points out, stocks in the top 10 today have much lower price-to-earnings multiples than the top-10 stocks did in 2000, and the companies are far more profitable as well.
Beyond that, not all of the Magnificent Seven are so magnificent. Alphabet’s stock has performed roughly on par with the market this year. Apple’s stock, meanwhile, is down more than 10 percent year-to-date on concerns about stagnant earnings and the U.S. government’s antitrust suit against the company. And Tesla’s stock has been a big loser, with investor worry about slowing sales growth and increased competition from China sending it down more than 30 percent. The Mag Seven have become the Big Four. Even so, the stock market has continued to do well. This suggests that fears about the dangers of market concentration have been overblown.
On top of which, the stock-market rally has broadened this year. In the first quarter, every sector of the market but real estate rose. In fact, if you look at all of the stocks in the S&P 500 except the Magnificent Seven, they were up 8 percent on average in the first quarter, a more than respectable return.
As the drops in Apple and Tesla shares show, investors are not simply buying across the board. They’re actually distinguishing among companies based on their earnings prospects, a behavior that’s generally not characteristic of bubbles. And few of the other signs of bubbles are present, either: American retail and institutional investors still have trillions of dollars in money-market funds (thanks to the high interest rates such funds now offer) rather than in the stock market. And instead of trying to cash in on their stock prices by issuing more stock, companies are continuing to buy it back.
Another indicator is that the market for initial public offerings has stayed relatively mellow, despite a few high-profile offerings such as Reddit and, of course, Donald Trump’s meme-stock company. That’s radically different from what you usually see in a bubblicious market. In 1999, for instance, there were 476 IPOs. This year, we’re on track for about 120.
No question, current stock-market valuations are rich. And plenty of factors could derail the rally, including high oil prices and weaker-than-expected earnings. The most obvious source of concern is that investors have been assuming that the Federal Reserve will cut interest rates this year, which may be too optimistic with inflation continuing to rise at more than 3 percent, still well above the Fed’s 2 percent target. If those rate cuts don’t materialize, stock prices could take a hit (as we saw yesterday, when the market fell after the government reported that inflation was hotter than expected last month). But it won’t be a bubble bursting—because there is no bubble to burst. Ignore the perma-bear noise, because the signal is in the fundamentals.
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