Throughout 2023, Wall Street pundits worried about the direction of the U.S. economy and the financial markets, with many predicting a recession—and possibly a market dive—within the next year. Much of this concern was based on the Federal Reserve’s aggressive stance on interest rates and its presumed willingness to risk an economic contraction in order to contain inflation. “Higher for longer” was the mantra, referring to the dramatic rise in borrowing costs that had begun the prior year and the Fed’s presumed determination to keep monetary conditions tight. Nevertheless, the equity averages rose through the year, and an unexpected relaxation of the Fed’s policy stance led to a surge that resulted in a strong finish for the markets at year’s end; the most prominent U.S. averages ended up from 26% to 45%, more than reversing the 18% to 33% declines in 2022. Interestingly, both 2022’s drop and 2023’s pop were attributable to the same phenomenon: the behavior of a small group of big technology issues, without which the movement in the indexes would have been much less remarkable. The “Nifty Fifty,” “FAANGS,” and now the “Magnificent Seven,” all refer to an irregularly-recurring stock market phenomenon in which a small number of companies with large market valuations have an outsized impact on capitalization-weighted indexes such as the S&P 500, the most widely-followed market gauge. For several years now, this group has been comprised of mostly big technology companies such as Apple, Netflix, and Google (Alphabet), with a new momentum-player darling, Nvidia, muscling its way into the group over the past year.
This trend was already evident at mid-year when the S&P 500 had gained 14%, solely due to the “MAG7.” Without those issues the average was essentially unchanged—the most concentrated market in 50 years. In September, after a difficult month for the equity markets, the index had gained 11% year-to-date, all due, still, to the tech behemoths. A modified version of the S&P 500 in which the constituents are equal-weighted, as opposed to capitalization-weighted (thereby reducing the impact of the biggest issues) now showed an actual decline of about 4%. Towards year-end, in December, thanks to the pop in prices, the equal-weighted index had gained about 11.5%—an excellent return normally, but far below the standard S&P 500’s return in excess of 26%, demonstrating the extent of the favored stocks’ impact on the so-called “broad” market averages that many investors look to as a simple way to get widely diversified equity exposure.
Which of these measurements more truly reflected market dynamics in 2023? Both have value, but in this case, and especially at current elevated price levels, the S&P 500 might be better considered an “index of speculation,” showing just how far market participants are willing to throw money at popular stocks with rapidly rising prices. The equal-weighted index, on the other hand, by reducing the oversized impact that the favored few issues have on measured market results, reflects a more sober assessment of equities in general, and is, in our view, more indicative of the current state of the equity universe. Market returns in the equal-weighted index being more modest (even negative at times) last year may indicate that the stock market in general is not as extremely overvalued as some would believe. The fact that nearly three-quarters of index components failed to match the average return also lends support to that view.
Why is this distinction important? The standard S&P 500 clearly attracts the most attention, given how much money is invested in funds tied to the index. But index fund buyers now face a quandary forced on them by the index’s structure and reflected in its price: buying the index currently means that 30% or more of each investment dollar goes into a small set of very expensive issues (or 50% in the case of the NASDAQ Composite index), a fact that can have serious consequences. A sudden souring on the MAG7 would undoubtedly impact the capitalization-weighted average negatively. Those taking the indexing route at the market peak in early 2000 suffered losses as that era’s behemoths collapsed, dragging down the index in subsequent years, even though most stocks were rising in price at the same time. In early 2000, equal-weighted indexes reflected the reality of a stock market in which most issues had significantly declined in price. This is why investors such as ourselves, who generally shun popular and over-hyped issues, tend to produce results that zig and zag with (rather than follow) the markets.
Another reason for taking the capitalization- versus equal-weighted distinction seriously relates to the concept of the price mechanism in economics. Prices are important in the allocation of resources in market economies, as they “signal” information to players about relative demand and supply. Rising prices encourage, and falling prices discourage, the production of goods. Stock market averages are gauges of prices in the securities markets and provide a similar signaling function, in this case encouraging or discouraging the raising of capital by businesses, and, conversely, the willingness of investors to provide that capital. To the extent that market gauges distort perceptions of market conditions, they can lead to poor capital allocation, which happened in 1999 and early 2000, as well as in other times of market exuberance. Those who remember, or who were, sadly, burned by, the likes of “Pets.Com,” can bear witness to the importance of this concept.
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Last year’s bounce back from 2022’s dive was unusual for its concentration in a few issues, but it frequently happens that a fallen market sector will subsequently rebound after hitting a low point. For many years, High Tech in particular has shown a remarkable tendency to recover after downturns as the sector has offered genuine business growth during what has been a challenging time for many industries. In this case the strength of 2023’s tech liftoff reflects a new speculative frenzy surrounding “AI” (artificial intelligence) that has engulfed the big tech names, including stodgy old IBM.
Essentially, AI involves the use of machine learning algorithms and vast amounts of data to create outputs that mimic human intelligence in a number of ways, including natural language interactive chat systems, text composition, and image creation. It is currently unclear where AI will lead us. There are some promising applications such as medical diagnosis and research, but there are serious concerns that the technology’s ability to produce realistic images and text could be used for deleterious purposes such as cybercrime, fake news, and political manipulation, all of which pose serious threats to society. In our view, most of the claims and fears about AI are speculative. One actual fact is that outside of a few computer chip manufacturers there is no indication that any of the companies deploying AI are making money from the technology. Will AI take over the investment business? We doubt that machines will be able to predict the future any better than humans.
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Because 2023 marked the fortieth anniversary of our entry into the investment field it seems fitting at year-end to muse about the changes we have witnessed over that period, as well as the financial and market events that stand out in our memory. Indeed, the changes are many, most relating to the mechanics of trading securities and the delivery of information. The character of Wall Street has changed as well, as reflected in the decline of its research arms and its standing in the public consciousness. The Street has a different feeling to it as well, as the world exemplified by the old Wall Street Week television program no longer exists.
What we find more meaningful is to look back on the experiences that led us to adopt the investment approach we have practiced for most of that 40-year period. Investing is not simply about following certain analytical steps to reach a conclusion. Analysis is important, but more significant is the investor’s way of thinking, or one’s “intellectual framework” as it has been called, the set of principles that guides and focuses the endeavor. For us there were two experiences that shaped our views of the investment process and led us in the direction we have taken.
Not long after joining a Wall Street firm after business school we made the acquaintance of a gentleman who had been an analyst, investor, and advisor since the late 1940s. One day, in the course of a conversation, he mentioned that he and his clients had owned shares of a particular company for at least a couple of decadesat a cost of about $4 per share (the company, a “blue chip,” then sold for around $150 per share). With this one remark out went everything we had been exposed to in business school about covariance, efficient frontiers, and all of the other statistical concepts associated with so-called “modern portfolio theory.” At that moment it dawned on me that investing was really about owning shares in significant businesses and holding them for very long periods. That was how much of the wealth in the U.S. had actually been accumulated. For one who had been exposed to a culture of stock trading, this was an invaluable lesson.
The second major impact on our thinking came from reading works by investment practitioners who had a deep understanding of accounting and business analysis, but who had also worked in the profession during harrowing times, in particular the Great Depression, when stock valuations sank to almost unimaginable lows compared with the experience of most modern practitioners. Foremost among them was the text Security Analysisby Graham and Dodd, the “Bible” of investing. Graham and Dodd, and other authors active during the same time period (1920s-1930s), also introduced us to a way of approaching market investing that has virtually disappeared from discourse on Wall Street, but one that we believe still holds great value in discerning potential investments, which is understanding the distinction between investment and speculation. Recognizing that much of what passes for investment analysis on Wall Street and in the financial media is in fact speculation is a great time-saver. True investment is relatively rare.
This framework has guided our activities in the field for over thirty years and we find that it works satisfactorily. Will AI replace us? Some years ago, one financial academic, steeped in modern portfolio theory and mathematical methods, said of the investment and speculation distinction: “an uninteresting matter of semantics.” If AI is fed a steady diet of “conventional market wisdom,” it may very well fall into the same trap.
Dennis Butler, MBA, CFA
Commentary