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Nikola Jokic was Robbed – and is a good lesson about this market

Financial Planning Dentist

Let me tell you about Nikola Jokic, the Denver Nuggets’ skilled center, and basketball poet. Despite his impressive performance, he was unfairly overlooked and missed out on his third MVP recognition. Jokic’s numbers in the 2022-2023 season were exceptional – and he represents the most “value” any player in the NBA brings to his team.

When Jokic is on the court, the team boasts an impressive +380 plus/minus* rating for the season. However, when he is not playing, their plus/minus rating drops to -201. His individual contributions are highlighted by his average plus/minus per game of +6.1. If the Nuggets performed at an average level without him, their win/loss record is projected at 58-24. However, without Jokic, their Net Rating plummets to -7.7, resulting in an expected win/loss record of 22-60, a significant decline of 36 wins.

Although it’s disappointing that Jokic didn’t win his third MVP title, it’s crucial to recognize and appreciate the impact he makes, similar to the mega-cap group of $1T companies discussed below, and how it relates to the U.S. stock market. Likewise, when the five largest companies by market cap are removed from the S&P 500 we see a much different performance than we’re seeing right now… 

A tale of two indexes: 

On May 30th, Nvidia made headlines by joining the exclusive $1 trillion club for the first time. As a maker and designer of A.I. hardware and software, Nvidia achieved this remarkable milestone by raising its valuation by a staggering $280 billion or nearly 40% since May 15th. This extraordinary leap in value is unparalleled in the history of capital markets, although the company closed just below the trillion-dollar mark.

However, there is a downside to Nvidia’s success, which reflects the overall trend of trillion-dollar companies this year. The five members of the Trillion-Dollar Club, including Apple, Microsoft, Google parent Alphabet, Amazon, and now Nvidia, have witnessed a synchronized surge in their market valuations. This surge among a select few has single-handedly propelled the S&P 500 index to +9% YTD. Without these “Super 7” (including Facebook and Tesla) the rest of the SP500 has moved less than 1% for the year. While the +9% move of the SP500 may seem positive at first, it raises concerns about the market’s dependency on these few mega-cap companies. The exorbitant prices they have reached may already be stretched to their limits, making it unlikely for them to sustain the market’s upward trajectory. The rise of Nvidia exemplifies the frothiness that has enveloped the Trillion-Dollar Club.

The Trillion-Dollar Club has accounted for nearly all the gains made by the S&P 500 this year. Apple, Microsoft, Alphabet, Amazon, and Nvidia have each experienced significant increases in their market caps since January, with Nvidia leading the pack at a remarkable 176%. Together, the current members of the Trillion-Dollar Club have added a staggering $2.87 trillion to their combined market cap since the beginning of 2023. These were names that we were and in some cases still are bullish on, but the concern then comes from looming weakness in other parts of the market. 

Interestingly, this rise is only slightly higher than the overall increase in the S&P 500, which stands at $2.98 trillion. Consequently, the Trillion-Dollar Club’s contribution amounts to 96% of the 9.5% year-to-date increase in the index. In essence, we can think of the Trillion-Dollar Club as a company called “Big 5 Llc”. This “company” has seen its valuation surge by 46.2% from $6.2 to $9.1 trillion. On the other hand, the remaining 495 companies in the S&P 500 have only experienced a combined gain of 0.3%. 

Without the tremendous boost from the Trillion-Dollar Club, the S&P 500 would essentially be flat for the year. We have been bullish on these chip makers and tech companies for some time (examples below) but think the recent run is getting a little too exuberant and divorcing from the broader market. 

Places where we discussed the potential in the AI and Chips group:

The Bifercated Landscape of the “Technology” Group: Exciting Investment Trends to Follow

The investment opportunity in semiconductors

When does a Bear look like a Bull?

The overwhelming weight of the Trillion-Dollar Club has made the S&P 500 lopsided. At the end of 2022, the club accounted for 17.6% of the S&P’s total valuation. Now, it represents 25.6%, meaning that more than one dollar in four is attributed to these mega-cap companies. As their combined market cap has increased by nearly $3 trillion in just five months, the Big Five have become significantly more expensive. Their overall price-to-earnings (P/E) ratio, which is the total valuation divided by combined net earnings, has risen from 27.7 to 40.6. This indicates that investors are receiving 33% fewer dollars in earnings for every $100 they invest compared to Christmas of 2022. To put it in perspective, the current P/E ratio for the Trillion-Dollar Club is almost twice that of the overall S&P 500.

This situation is concerning, considering that the Trillion-Dollar Club has already achieved substantial earnings growth since the start of the pandemic. In 2022, these seven companies generated approximately $224 billion in net profits, which was 50% more than their pre-COVID earnings in 2019. Therefore, the high multiples at which they are currently trading come on top of potentially unsustainable profit levels. The concern from here is that any weakness in this small group would be felt significantly in the broader market. 

This narrow leadership can be a good sign if the momentum becomes contagious and the cash on the sidelines is brought into the market. But while cash is so lucrative, the velocity at which the cash comes into a market expecting a recession is unlikely.

However, three main risks persist:

Interest Rate Risk – More Constrained Lending Coming:

One significant risk in the current market is the potential for more constrained lending due to interest rate changes. When interest rates rise, borrowing becomes more expensive, which can lead to reduced consumer spending and business investment. Higher interest rates may also discourage lending institutions from extending credit, making it more difficult for individuals and businesses to access funds. This can have a dampening effect on economic growth, as it reduces the availability of capital for productive activities. Consequently, this risk may hold back market participation as investors become cautious about the potential impact of tighter lending conditions on corporate earnings and consumer spending.

Inflation Risk – labor costs are still rising:

Inflation risk refers to the possibility of a sustained increase in the general price level of goods and services. When inflation rises, the purchasing power of money decreases, which can erode the value of savings and investments. The costs for labor are still coming up and much of the inflation that receded in the recent PCE print is accounted for.

Inflationary pressures can be fueled by various factors, such as increased demand, supply chain disruptions, or expansionary fiscal and monetary policies. In response to inflation, central banks may raise interest rates to curb excessive price growth. However, higher interest rates can also have a negative impact on economic activity and investment. Investors may be concerned about the potential effects of inflation on the profitability of businesses, as rising costs may eat into margins and reduce consumer purchasing power. This risk may lead to cautious market sentiment, as investors assess the potential implications of inflationary pressures on corporate earnings and asset valuations.

Companies are showing excellent resilience in passing on inflation to consumers, but the limit for what consumers can bear will be discovered this summer. Cash reserves for households are dying up, credit is stretched, and some of the early signs of cutting are showing up in Home Depot, Target, Dollar Tree, Walmart, and other retail earnings.

Recession Risk:

The possibility of a recession is another risk that will keep investors on the sideline.

A recession is typically defined as a significant decline in economic activity, often characterized by falling GDP, rising unemployment, and reduced consumer and business spending. It may not look like that this time, but the anticipation of slower economic growth is a well-adopted scenario.

Recessionary periods are challenging for businesses, as they face declining revenues and profit margins. This can lead to reduced investor confidence and a decrease in stock market participation. Investors may adopt a more risk-averse stance during periods of economic uncertainty, reallocating their portfolios to safer assets or adopting a wait-and-see approach. The fear of a recession and its potential negative consequences on corporate earnings and overall market performance may result in reduced market participation.

In summary, the risks of interest rate changes, inflation, and recession can impact market participation. The tightening of lending conditions due to rising interest rates, the potential erosion of investment value caused by inflation, and the economic challenges associated with a recession may lead investors to adopt a cautious approach, potentially holding back their engagement in the market. It is crucial for investors to carefully assess and manage these risks to make informed investment decisions.

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