Stocks once again moved higher yesterday in rather quiet trading. One item of note: the yield on 10-year Treasuries, now back below 1.75%, has given up roughly half of its rise from late summer lows reflecting the nation’s tepid economic performance.
So why are stocks doing so well? You have read the list of reasons before. Trade talks with China seem to be moving forward, although there doesn’t seem to be an end date that we can write in ink. Europe seems to have stabilized. Third quarter earnings were at least as good as expected. Earnings next year, according to analysts, are expected to rise at a faster pace than in 2019. Interest rates remain low. That means P/E ratios can remain high. Based on estimated earnings in 2020 of $170, stocks now trade at 18.5x next year’s estimated results, certainly higher than historic averages, but below the frothy levels seen in times of euphoria. In other words, markets may be a bit extended but there is no reason they don’t have further to go.
But wait a minute. Yes, the averages are at record highs but that doesn’t mean all stocks are at new highs. If you own anything in the energy universe, you are certainly not celebrating. But the energy sector is now less than 5% of the S&P. If I ignore Exxon# and Chevron#, the rest is closer to 2% collectively. Industrial stocks are feeling tariff pain; they too are well off their highs. With the climb in rates this fall, income-oriented stocks, like utilities and REITs, have backed off their highs. The same goes for so-called safe stocks like consumer staples. The IPO darlings of a few months ago are behaving badly. Beyond Meat, still selling at a very lofty valuation, is down two-thirds from its summer peak. Uber and Lyft are well below their IPO prices and well off their highs. WeWork, renamed just We, never got the chance to go public and now is valued at about 25% of its early 2019 valuation.
What has been working are Apple# and Microsoft#. Collectively, these two stocks now account for 8.8% of the S&P 500. Apple is up 71.4% this year and Microsoft is up 49.8%. Do the math and you will see that these two stocks alone account for 5.3% of the S&P’s 23.4% rise year-to-date. Said in a different way, Apple and Microsoft account, by themselves, for almost a quarter of the rise in the market. Of course, without these two giants, stocks would still be up about 18%, not exactly shabby. But this exercise in arithmetic has a point. If you want to beat or match the market, you better own the stocks that are working. Apple and Microsoft are the most important because they are the two largest weights on the S&P. Not only must you own them, you need to have meaningful positions. As noted above, Apple and Microsoft are 8.8% of the market cap of the S&P 500. To beat the market, these two stocks need to be more than 8.8% of your portfolio.
All of this is part of the exercise of beating the market. Last year, you had to own Amazon and Netflix. Each year is different. But let’s step back. What is your goal? Is it to beat the market? Or is it to grow your capital in a prudent manner. If you own a portfolio of really good, well performing blue chip companies that might include names like Merck#, Coca Cola#, and Home Depot#, you will be doing just fine and collecting bigger dividend checks each year. Over a long span of time, you probably have kept up with the market, maybe even beaten it. It wouldn’t be imprudent to own some Apple and Microsoft either. But chasing the winners each year, i.e. chasing momentum, is a fool’s game. By the time the chase catches up, leadership changes.
The goal of any long term investor should be to identify a diverse group of companies that can grow for the foreseeable future at or above the overall growth rate of the economy. Those companies should be able to increase dividends in line with the growth of earnings and free cash flow. Assuming that one doesn’t collectively overpay initially for this bread basket of companies, over time the investor should be able to grow his capital, earn a superior return to inflation and the overall market, and enjoy a growing stream of dividends. All companies will not beat the market in any one year. Who would have thought a year ago that Apple’s stock could rise 71% while its earnings were actually declining? Why is a story for another day. The point is that Apple’s stock is up because it is perceived as a more valuable long term holding than it was a year ago.
It’s nice to beat the market and it is even nicer if you can do it in a year as strong as 2019. But if the true goal is to attain real growth at least as good as long term trends suggest, i.e. 7-9% per year on average, then prudent portfolio management suggests it is more important to prune those companies with deteriorating long term performance and replace them with alternative growth stocks that are fairly valued. As Warren Buffett likes to say, I would rather own a great company at a fair price than a fair company at a cheap price.
Today Bill Nye (the Science Guy) is 64.
James M. Meyer, CFA 610-260-2220