This market is nothing like the dotcom bubble
Regardless of what happens in the next several years, AI is likely to pay off big for long-term investors
A LOT of people are watching this meteoric US stock market with amazement as it shakes off one worry after another – slowing labour market, sagging consumer sentiment, continuing trade uncertainty, geopolitical tensions and now a US government shutdown – on its way to new record highs.
Some see a replay of the late 1990s Internet bubble, but this time fuelled by artificial intelligence (AI).
Investors seem to be asking, in various ways, if this rally is overdone and, by implication, if the market is due a pullback.
One answer is that stocks care about only one thing – earnings growth. From that limited perspective, the future looks bright. Wall Street analysts expect that 95 per cent of companies in the S&P 500 index will grow earnings next year by an average of 16 per cent, according to estimates compiled by Bloomberg.
Having the most impact will be the eight biggest companies in the index by market value: the Magnificent Seven and Broadcom, which collectively account for 37 per cent of the S&P 500. They are expected to grow profits by an average of 21 per cent. So long as that growth is not in jeopardy, nothing else really matters.
Investors are also getting more for their money than they did in the dotcom days.
Annual profitability for the S&P 500, as measured by return on equity, has been higher in the last four years, at around 18 per cent, than at any time since at least 1991. And, with less leverage: The index’s debt-to-equity ratio is near 100 per cent from more than double that in the late 1990s.
Much of that improvement is attributable to the Magnificent Seven and Broadcom, which posted a weighted average return on equity of 68 per cent last year – more than double that of the biggest eight companies at the peak of the dotcom bubble in March 2000. As a group, today’s market leaders also carry nearly half as much financial leverage as the dotcom cohort.
Profitability fuels earnings growth, which is what ultimately pushes stock prices higher. It is why investors usually pay a premium for more profitable or faster-growing companies.
The forward price-to-earnings ratio of the S&P 500 Growth index, for example, has almost always been higher than that of the S&P 500 Value index since 2001, with an average premium of five points over that time. Today’s market is not as screamingly expensive as the dotcom one, once you have accounted for the higher profitability – and expected growth by extension.
Growth forecasts
Still, on an absolute basis, the market’s valuation is near the dotcom peak. If companies want to hang on to these lofty multiples, they will have to deliver. The likelihood depends largely on how much growth the market expects. Growth expectations cannot be observed directly, but there are clues.
Wall Street analysts expect S&P 500 earnings to grow by 10 per cent a year over the next three to five years, based on individual company estimates compiled by Bloomberg and weighted by companies’ market value.
That is probably too optimistic, and certainly well higher than the index’s long-term earnings growth of closer to 7 per cent since the 1950s.
Growth estimates for the market leaders are even rosier – in the mid-teens for most of the Magnificent Seven, and closer to 40 per cent a year for Nvidia and Broadcom.
The market has its own, more sober forecast.
Another approximation of companies’ expected earnings growth is the difference between their cost of equity – essentially, the return investors demand to own shares – and their earnings yield. As things stand, the S&P 500’s weighted-average cost of equity is 10 per cent, and its forward earnings yield is 4.4 per cent, implying medium-term earnings growth of 5.6 per cent a year. For the Magnificent Seven and Broadcom as a group, the implied growth rate jumps to 8.6 per cent.
The market’s more modest expectations are very achievable, but not necessarily bullish for medium-term returns.
If companies deliver what is expected, and the market rewards them by maintaining their elevated valuations, investors should collect their 5.6 per cent earnings growth in addition to the S&P 500’s dividend yield of 1.2 per cent, for a total return of about 6.8 per cent a year. That is less than half the S&P 500’s total return over the past decade.
A lesson often forgotten
But regardless of what happens in the next several years, AI is likely to pay off big for long-term investors. That is an often-forgotten lesson of the dotcom era.
If you had bought the S&P 500 at the peak of the bubble in March 2000 and hung on all this time, your investment would have grown sevenfold, including dividends.
And if you had bought the index as the Internet emerged in 1995 and ignored the hype and doomcasts along the way, your money would have ballooned 26-fold.
Despite the endless arguments about the future of AI – the same squabbles I heard about the Internet three decades ago – I have no doubt that AI will be at least as transformative and valuable, and that much of the value will end up in investors’ pockets.
Those scared off by elevated valuations in recent years have already given up a good chunk of it. The S&P 500 has delivered 16 per cent a year over the past five years and 15 per cent a year over 10 years, much of it driven by Big Tech and easily beating the index’s long-term average return of closer to 9 per cent a year.
Do not be surprised if this market refuses to be derailed by politics or the broader economy. There is no reason the market has to fall apart, particularly if companies continue to feed it the growth it wants. BLOOMBERG
