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Welcome to Fantasyland
Melt-up mentality brings back memories of of stock market magic
It’s wild how quickly memories fade on Wall Street, and how fantasies can overtake reality for a surprisingly long time...
Trying to fight the urge to chase the latest and greatest – no matter how rational the argument against doing so might be – can be brutal. As the never-gets-old saying goes...
The market can remain irrational longer than you can remain solvent.
But here we are, a mere two years after dot-com 2.0, and we’re having the same discussion… again!
This time it’s the artificial intelligence (“AI”) “melt up,” everybody seemingly talking “melt-up,” and the market back to doing what it does best... very likely generating its own form of magic, complete with illusions, sleight-of-hand and skillful misdirection.
There’s no question AI is real, impactful and evolving quickly, but the way its latest iteration has jump-started the market is a “we’ve seen this movie before” moment.
And in a market whose performance is dominated by just a handful of companies, investors seem to be losing sight of the real story...
And it’s not just that that the best performance on the market capitalization-weighted Nasdaq 100 is concentrated in just seven names: Microsoft (MSFT), Apple (AAPL), Nvidia (NVDA), Amazon (AMZN), Meta (META), Alphabet (GOOGL) and Tesla (TSLA). Together, they account for around 55% of the index’s weighting.
There’s no question: that’s insane, and it’s the focus of quite a bit of chatter. The great financial journalist Allan Sloan, writing in Barron’s the other day, calls it the “Skinny Bull Market.”
Even more insane, however, is that this time the data is pointing to something even more astonishing, and it’s this...
If chosen carefully, other stocks in the very same index are cheaper and growing faster than the best performers.
To prove this point, my pals at the quantamental research firm, Kailash Concepts (“KCR”), frequently quoted here, dove into the Russell 1000 Growth index... zeroing in on the top 30 stock.
They found a few things:
First, that the top 30 stocks in the index are growing considerably slower than the top 30 did during dot-com 1.0.
Second, even though they’re the most watched stocks, they’re just barely beating the broader index.
Third, to get that level of under performance, investors have to pay a premium.
As KCR explained in a recent report on how to make money in mega-cap stocks (emphasis theirs)...
Let’s pretend you have total confidence that the biggest weights today will keep winning. Let’s then pretend you put 100% of your money in just those top 30 stocks, and they did, in fact, beat the broad Russell 1000 Growth Index by 5% a year. Genius, right?
Not so fast. Even with perfect foresight and a 5% annual advantage compounding away for your 30-stock portfolio, you actually outperform the broad R1G index by only 1.7% a year on average! Don’t believe us? ... The math is a merciless reminder that 1) the index is already incredibly concentrated, and 2) there is very little benefit to making even bigger bets on the top 30.
They go on to add (emphasis by them and me)...
The only difference we can see is that today, the stocks with the largest market capitalizations are actually growing profits at less than a third of the rate they were at the prior peak (49% today vs. 175% then).
That’s all summed up in the two tables below. The first shows just how less-than-dazzling the growth is at the most dazzling stocks…
The second table is just as compelling. It shows quite clearly that if investors dug just a little deeper into the same index and were a bit more selective, they can find stocks that are cheaper, have greater earnings growth and more likely to perform better than the top 30. (In the below table, Kailash’s picked 30 stocks from the index, which are labeled KCR R1000G portfolio.)
There’s one other thing, and it may be the most important point of all…
As KCR points out in a different report last week, five of the seven stocks that dominate the Nasdaq 100 “have been deemed AI winners,” resulting in “multiple expansion gone mad.”
But if we’ve learned nothing else over the prior cycles and technologically led euphorias, it’s that first-mover advantage doesn’t always guarantee winning in the end.
What’s more, with so much money flowing into AI, it’s unclear who the ultimate winners will be. That led KCR to ponder…
If you don’t know who the future competitors to current incumbents are, how can you forecast profits with any confidence? If a business’ competitive position is suddenly the great unknown, does it make sense to pay the highest multiples in history for these stocks?
The answers, of course, are that under those circumstances you can’t forecast with confidence and… no, unless you’re in it for a quick trade or have a special line into the future, it doesn’t make sense to pay the highest multiples ever for these stocks.
That gets to the moral of this story: No matter how much lip service investors give to learning the lessons of the past, they really are like a herd...
They understandably prefer the adrenaline rush of being part of the popular crowd, and as much as they should know better, really do fear missing out on something big.
For everybody else, bucking that trend isn’t always easy, and as KCR puts it...
Along the way there will doubtless be bumps on the relative performance side as investor infatuation with quality at any price and AI drives short-term results. But for disciplined investors unwilling to be shaken by the comical claims of market efficiency by the indexing crowd, there are profitable high-growth stocks that the data suggests will compound at rates far above the index.
Pure growth investors might argue that the data is just that: data that is looking in the past, not the future.
They have a point, but so does history. And while the current catch phrase is “history rhymes,” the reality is that when it comes to this kind of momentum… history really does have a way of repeating itself. This time will be no different.
DISCLAIMER: This is solely my opinion based on my observations and interpretations of events, based on published facts, and should not be construed as investment advice.
Feel free to contact me at email@example.com. You can follow me on Twitter @herbgreenberg.
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