We Americans invest more of our 401 (k) plans in stocks than in any other asset class. Overall, we hold 39% of the money in equity funds and a further 26% in “target date funds”, which, depending on age, also throw smaller or larger amounts on the stock market. Most of it is in the US stock market, and most of it is in the stocks of big companies in the S&P 500
So to the retirement prospects of tens of millions of workers, nothing is as important as the current level of the S&P 500 and its likely future returns.
Before anyone gets complacent and rejects talk of a stock market bubble, take a look at this killer chart provided by money managers GMO in Boston.
It shows that today a full quarter of US stocks are being sold for more than ten times annual sales – a generally ridiculous overvaluation. Not only is this the highest percentage of stocks sold at stupid prices since the infamous tech bubble 20 years ago. Historically, we've never seen anything like it, except in these two episodes: 1999-2001 and today.
This does not mean that the entire US stock market is in a bubble. It means there is an undeniable euphoria when it comes to the sexy "growth area" of the market.
Ben Inker, head of asset allocation at GMO and author of the report, reminds us of what "10x sales" really means.
He quotes Scott McNealey, CEO of Sun Microsystems, and his famous comments on it almost 20 years ago, after the last technology bubble burst.
"Two years ago we were selling 10 times our sales," McNealey said in 2002. He talked about the impossible financial feats Sun would have had to do to justify that stock price. "Do you realize how ridiculous these assumptions are?" He asked investors. "What did you think you were doing?"
It was a good question. It still is.
GMO shows that since 1980, stocks bought for more than 10 times the annual sales have been a terrible investment overall, bringing in half the annual return of the entire S&P 500.
The late great investment manager Peter Bennett used to say that knowledge of financial history is more important than knowledge of financial theory. One reason: stock market fashions are cyclical, they have always been, and during each period investors insist that current fashions are permanent. (After all, if they didn't, they wouldn't buy the stock).
Stocks generally fall into two categories, "growth" and "value". (I sometimes think of "future" stocks and "current" stocks). So-called growth stocks are usually more expensive in relation to current sales, profits, etc., because investors are going for big things in the future. As with anything, you can overpay. Everything has it's price.
Right now we're in a growth stock mania. The valuation gap between growth stocks and “value” stocks is close to record levels, according to GMO data. We're not quite at the 1999-2000 level, but we're close.
Growth stocks have beaten value stocks by a long way in the past 15 years. But the GMO analysis, which mirrors that of hedge fund manager Cliff Asness, shows that this outperformance was entirely due to valuation changes. Growth stocks just got a lot more expensive. Extrapolating this into the future means double counting or circular reasoning.
Incidentally, I should praise GMO co-founder Jeremy Grantham, who is too often dismissed as a "permanent bear". In 2007, when “value” stocks were booming and “growth” was still in the drawer after the dotcom bankruptcy, I met Grantham at an industrial dinner. He then predictively told me that growth stocks looked cheap. A great call.
At this point it is worth remembering that the stock market is a huge, ongoing experiment in mass psychology. Fashions and fads come and go. After all, humans are only the third branch of the chimpanzee family, and chimpanzees are pack animals. Betting on the further outperformance of growth stocks means, as Ben Inker argues, counting on several implausible mathematical assumptions. But it can also be argued that people on the stock market are no longer subject to fashion and pack behavior – a very high odds bet, I would have thought.
We never know when the pendulum will swing back the other way. The past is of course no guarantee of future performance. But as a long-term investor, I would rather have “value” equity funds than “growth” funds in my retirement accounts. I prefer the odds.