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The DOW Is Hot- Will it Burn Us?

The DOW Is Hot- Will it Burn Us?

January 29, 2021
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Many people have asked me, “why is the market so hot when we’re in the middle of a pandemic?” Because -people have money and they don’t know what to do with it. When we can’t spend it (because there’s nothing to do!) what would you do? Probably the same thing everyone else did, they bought stock. As I’ve always explained, due to supply and demand, the price of something will rise if we all start bidding on it! I recently read a really interesting fact about the markets. My mother-in-law remembers her high school world affairs teacher saying that if the Dow ever hit 2,000 that we would be setting ourselves up for doom. Well, as I write this (January 28th) the Dow closed last night at 30,303.17. So are we in for doom and gloom?!

I wouldn’t base my thoughts on her instructor’s theory because things have changed so much since then. That was back in the late 60’s and since then, starting in the early 80’s, the typical market investment has changed dramatically due to the invention of the 401(k). These plans put money in the hands of the average person, which created an enormous influx into the market. Prior to that employers used pension plans which typically invested in direct holdings of the Treasury, agency-backed, corporate and foreign bonds.5 The 401(k) created a place for investors to eventually get massive amounts of money invested into the market. This caused a supply and demand scenario where the influx of cash all bidding on the same companies caused the share prices to rise. Of course that’s just one part of the reason why the market has grown since then, but it’s still a very influential reason.  

What’s interesting is what grew last year. Many of you are aware that the big tech guys (Facebook, Apple, Amazon, Netflix and Google, often referred to as FAANGs) were responsible for much of the S&P 500’s hot numbers last year. Similarly, FAAAM (which excluded Netflix and Google and instead included Microsoft) made up well over 40% of QQQ and over 20% of SPY as of early May with the rest of the US stock universe, including the equal-weight S&P 500, had been negative. 8 Even more astonishing is that together Apple and Microsoft are larger in market capitalization than all of the German stock market!9

As of January 26, 2021 Facebook (FB) is trading at 32X its earnings, Google (GOOG) and Microsoft (MSFT) are at 37X, Apple (AAPL) is at 43X, and Netflix (NFLX) is at 92X!1

So what’s going to happen this year? Who knows, right?

A quote from Scott McNealy, CEO of SunMicrosystems comes to mind here. While experiencing the Dotcom market drop, McNealy rhetorically asked his investors, “What were you thinking?” when they paid (what he called a “ridiculous”) ten times revenues for his stock during the height of the Dotcom Mania.2 At the bottom of that market drop his stock price had lost over 90% of its value. Think about that, that “ridiculously” overpriced stock was just 10X earnings! It turns out that 414 other stocks in the S&P 500 Index were selling at that same multiple just before the NASDAQ fell 83%. Today, nearly 60 of the S&P 500 Index companies are trading over 10X their revenues, obviously including the FAANGMs I mentioned above. 2


On the other hand…

Companies in the S&P 500 saw their cash levels rise 36% in 2020 to roughly $2.54 trillion, which is up from $1.87 trillion just before the pandemic. If divided equally, that’s basically $5 billion in cash for the average company in the S&P 500. 4

When companies have cash on-hand they tend to use it to buy back stock.  Free cash flow is a measurement of cash flow less long-term investments. It is expected to rise significantly in 2021, by as much as 29%! This suggests companies could very well use that idle cash to buy-back more stock, which, as I said above, creates another supply and demand scenario where share prices rise. 4

So what’s the moral of the story?

DIVERSIFICATION and TIME are the key takeaways. I’m not in it to market-time, I’m in it to make sure we’re in the right place at the right time. If we try to guess where to be, we’re likely going to be wrong. I know this because I’m pretty well schooled in this (both experience-wise and also academically-speaking) and my track record has not been 100% right. Look at the following chart made by Callan.

The Callan Periodic Table of Investment Returns conveys the strong case for diversification across asset classes (stocks vs. bonds), capitalizations (large vs. small), and equity markets (U.S. vs. global ex-U.S.). The Table highlights the uncertainty inherent in all capital markets. Rankings change every year. Also noteworthy is the difference between absolute and relative performance, as returns for the top-performing asset class span a wide range over the past 20 years.  www.callan.com/periodic table

Pick a color and follow it along the columns. How often is that one color at the top? How often is it at the bottom? Most colors that are at the very bottom are often the following year’s top.  Is that true for your color? Regardless, it’s important to remember that it’s truly anyone’s guess what will win in the future, but we’ll only know for sure when it is seen in the rearview.

And according to Capital Group, “time, not timing, is what matters”. 6 Good timing is nice, there’s no arguing that! But even if you had the bad luck of picking the worst day of the year to invest for a total of 20 years (ending in 2018) you still would have come out ahead (by as much as 6.91%, to be exact!)6 In other words, we should just continue to follow the rules of appropriate Asset Allocation and Diversification and be ready to ride the waves in between!

 

1 YahooFinance.com. 26, January 2021.

2 Felder, Jesse. The Felder Report- ‘What Were You Thinking?’ Part Tres. FelderReport.com. 6 January 2021.

3 https://www.callan.com/research/2020-classic-periodic-table/2020 Callan Periodic Chart. 28, January 2021.

4 Sonenshine, Jacob. Barrons.com. Stock Buybacks Have Fallen Off a Cliff. Why They’re Set to Make a Comeback. 8 December 2020

5 Broadbent, John, et. al. https://www.bis.org/publ/wgpapers/cgfs27broadbent3.pdf. The Shift from Defined Benefit to Defined Contribution Pension Plans- Implications for Asset Allocation and Risk Management. Pg 22. December 2006.

6 Investing Fundamentals. Time, Not Timing, Is What Matters. 28 January 2021.

7 Ritholz, Barry. Top-Heavy Stock Indexes Are Nothing to Fear. Bloomberg. 18 August 2020.

8 Twitter –@LynAldenContact - Lyn Alden. 7 May 2020 at 1:47PM.

9 Felder, Jesse. Felder Report –A Dangerous Gap Has Opened Up For U.S. Equities. 17 June 2020.

The S&P 500 Index is the Standard & Poor’s Composite Index of 500 stocks and a widely recognized, unmanaged index of common stock prices. You cannot invest directly in an index.

Past performance is no guarantee of future results. 

Asset allocation won’t guarantee a profit or ensure against a loss, but may help reduce risk and volatility in your portfolio. Diversification cannot eliminate the risk of investment.

The opinions expressed are those of the author and not necessarily those of Lincoln Financial Advisors Corp. Forward looking statements may be subject to certain risks and uncertainties.  Actual results, performance, or achievements may differ materially from those expressed or implied.

Carrie Waters Schmidt is a registered representative of Lincoln Financial Advisors Corp., a broker/dealer (member SIPC) and registered investment advisor. Equanimity Wealth Planning and Investing is not an affiliate of Lincoln Financial Advisors.   

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