Stock market enthusiasm is contagious. The frenzy doesn't just affect the stocks at the center of the frenzy. They spread and affect everything else.
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This is currently a significant and increasing risk for ordinary 401(k) and IRA investors. It's dangerous to get sucked into a mania stock like fast-growing chipmaker Nvidia NVDA (currently worth $2.4 trillion, or 36 times last year's revenue). But it's also dangerous to think you're avoiding these popular stocks by buying a simple index fund like SPDR S&P 500 ETF Trust SPY.
To understand this danger, listen to Francois Rochon, a veteran wealth manager for private clients based just north of the Montreal border. In a fascinating letter to clients, the founder and CEO of Giverny Capital warns them to beware of the “index waltz.”
Here's how it works: We'll start with a few giant stocks that are rapidly growing and leaving the rest of the market behind. This is what we've seen over the past year, with the so-called Magnificent Seven technology stocks: Nvidia, Apple AAPL, Amazon AMZN, Google parent Alphabet GOOG, Facebook parent Meta META, Microsoft MSFT, Tesla TSLA You can see the change. These accounted for most of the S&P 500's overall performance last year. These seven stocks alone now account for just under 30% of the total index value.
If a few large caps disappear from the market, what happens to the rest of the fund industry? They start to look really bad. Fund managers who don't own these stocks, or who have a more reasonable weight to them, wake up and realize that the stocks are underperforming the index and many of their clients have jumped into investing in index funds. Rochon says, .
It's been a hot topic for quite some time.
And these managers, like most humans, respond to the incentives presented to them from a self-interested perspective. “Motivated by the desire to avoid losing their jobs, an increasing number of these executives are throwing in the towel and buying up the top stocks in the index to limit the decline in performance,” Rochon said. do. These frantic purchases “push these stocks to new highs” and in return make other fund managers who are holding on look even worse. So they end up giving in and buying the fast-growing mega-caps.
It's a vicious cycle. (Or if you happen to own the right stocks, that's a good thing.)
This may be where we are now. It's notable that retail investors in the United States, who avoided the stock market during the past two years of bear markets, are now flooding back into the stock market. Investors have bought $73 billion worth of U.S. stock funds since the latest market boom began around Halloween, according to the Investment Company Institute, a trade group for the mutual fund and exchange-traded fund industries. This includes $45 billion he made in his first three weeks of March alone.
But in the first 10 months of 2023, when the market fell sharply, they sold $155 billion worth of U.S. stock funds. In other words, buy high and sell low.
But what can't last forever won't last forever. Sooner or later, this “index waltz” music will stop. I've seen this before in Mania as well. Of the top 10 companies on the S&P 500 50 years ago, not a single company is still on the S&P 500 today. none. Ah yes, Kodak, Sears, and Xerox stocks! It's a good time. There's no way those companies will go bankrupt, right?
Rochon's argument isn't that investors should get out of the stock market, just that they should temper their euphoria about some of the biggest stocks on the market. Mr. Rochon, a so-called value investor and follower of the late Charlie Munger, is adamantly against timing the market, rationally arguing that no one can predict its next short-term move. But his U.S. stock picks outperformed the S&P 500 by an average of 3.9 percentage points a year over 30 years, so he must have some idea what he's doing.
Meanwhile, the recent mania has been particularly concentrated in large-cap growth stocks such as the Magnificent Seven. Cheap and less exciting value stocks are being left behind. As a result, the Vanguard Value ETF VUV has significantly underperformed the Vanguard Growth ETF VUG, especially since the enthusiasm for artificial intelligence and the Magnificent Seven began in earnest early last year. The same goes for international stocks. Reclaiming your sense of well-being doesn't have to mean getting out of the market entirely.
Or you can just keep dancing to the index waltz.
