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Sound Advice: September 9, 2020

A Tale of Two Markets

"It was the best of times, it was the worst of times, it was the age of wisdom, it was the age of foolishness, it was the epoch of belief, it was the epoch of incredulity, it was the season of Light, it was the season of Darkness, it was the spring of hope, it was the winter of despair, we had everything before us, we were all going to Heaven, we were all going direct the other way----in short, the period was so far like the present period that some of its noisiest authorities insisted upon its being received, for good or for evil, in the superlative degree of comparison only."

Charles Dickens

The words Dickens wrote 161 years ago resonate eerily with where we are today.  For some people, it is indeed the best of times.  For far too many others, however, it is among the most difficult of times.

Amid the overwhelming flow of each day's news, we learn about the movements of the stock market, which until recently appeared to be on a fast track to the ionosphere.  Recent pullbacks, though, suggest that it is time for a reality check.

The market that the media usually refers to is either the Dow Jones Industrial Average or the Standard & Poor's 500 Index.  The Dow consists of 30 well-known stocks that used to be called blue chips.  The S&P, by contrast, is far broader, including huge companies as well as tiny companies.

Although the S&P appears to provide a more representative view, it does not.  Why? Because the S&P is weighted heavily toward the tech companies with the greatest market valuations.  These are often referred to as the FAANGs: Facebook, Amazon, Apple, Netflix, and Google.

For the year to date, the average gain for these five stocks is 51.7%.  If, however, we view the S&P Index on an equal-weighted basis, the year-to-date result turns out to be a loss of 10.6%.  That still includes the FAANGs.  Excluding those companies, the numbers are even worse, which is why many investors are still wondering why their portfolios are down even though the news media seems to indicate otherwise.

Are these great companies?  They are, but there are important issues to ponder.  In all cases, as companies grow, their potential for further growth diminishes.  Companies such as Amazon and Netflix have had extraordinary gains due to the pandemic, but there will come a time when folks are out and about again, not living online.

A decade and a half ago, Apple was at best an also-ran.  Then came the iPhone, which along with Samsung has largely saturated the world with handheld devices.  There may be more to come, but at a moderating pace.

Facebook, too, has been a major beneficiary of the current constraints, replacing actual social contact with digital contact, which may be better than nothing, but not quite as satisfying.

From the perspective of fundamental analysis, these are all richly valued companies, ranging from 34 times earnings to 121 times earnings.  That compares with traditional market valuations of 15 to 18 times.

When stock valuations are high, one or more of the following factors are needed to support them: an above average rate of future growth, consistent past growth, and low interest rates.  A hesitation in growth, even for a short time, can undermine a stock's price.

Chasing them may not be a good idea.

N. Russell Wayne, CFP®


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