Investors received some very good news last week, as a debt-ceiling compromise was reached in time to avoid America defaulting for the first time in our nation’s history. The bill, named “The Fiscal Responsibility Act” (no kidding), would suspend the debt ceiling through January 1, 2025. The legislation will slow the rate at which governmental spending grows, and thereby reduce government deficits by about $1.5 trillion over the next ten years, according to the Congressional Budget Office.
More good news came last week from the Labor Department, which reported that job openings in the U.S. rose in April, and nonfarm payrolls grew much more than expected in May. While this is great news for workers, it also raised the odds that the Federal Reserve will continue to hike rates at its next meeting in two weeks, and possibly beyond.
Mr. Market decided to focus on the positive, as all of the major averages rose for the week. The S&P 500 Index surged 1.5% on Friday, closing at the highest level since last August.
In last week’s email, I suggested that corporations buying their own shares as one of the reasons why the stock market has done surprisingly well in the face of a deficit battle. This week I’d like to touch on another, namely: the S&P 500 is the most concentrated it's been in decades.
As of the market’s close on Friday, the S&P 500's five-largest companies represent approximately 22% of the index's aggregate value, with Apple alone comprising over 7.5% thereof. This lack of diversification has been a major driver of the S&P’s stellar returns so far this year, but it could also be a harbinger of lurking trouble for the index.
Year-to-date, the S&P 500 is up approximately 12%, which has led to this widely followed benchmark trouncing more diversified portfolios. But it’s important to recognize that just seven tech stock giants -- Apple, Microsoft, Alphabet (a.k.a Google), Amazon, Nvidia, Meta (a.k.a. Facebook), and Tesla – have accounted for virtually all of the index’s gains. Without them, the bellwether index would be essentially flat for 2023.
The rich valuations to which these seven companies have soared has been aided by low interest rates, which have made their projected future earnings more attractive to investors. However, should the Federal Reserve decide to keep policy rates higher for longer, the attractiveness of these companies could suffer significantly.
The S&P’s strong recent performance has made it unusually expensive on a price-to-earnings (P/E) basis. Currently, the S&P 500 has a forward P/E of 23.55, as compared to its historic average of around 19.9. That suggests the index may be significantly overvalued at current market prices.
Mean reversion, one of the most powerful concepts in finance, stands for the proposition that stock prices and trailing performance eventually revert to their long-term mean, or average growth rate. If the gravitational pull of mean reversion brings the Magnificent Seven back to earth, their fall would have a disproportionately negative impact on the entire S&P 500 index.
That’s all for now. Have a great weekend, and invest wisely my friends.