Beware of Nvidia and S&P 500’s ‘index waltz,’ says market-beating fund manager

Hot stocks aren’t always good for the stock market. – Getty Images/iStockphoto

Stock market manias are contagious: They don’t just affect the stocks at the center of the frenzy, but they spread, affecting everything else.

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This is a significant and rising risk for the average 401(k) and IRA investor today. That’s a danger as they get sucked into cult stocks like soaring chip maker Nvidia NVDA (current value: $2.4 trillion, 36 times last year’s revenue). But if you think you’re avoiding these popular names by buying simple index funds like the SPDR S&P 500 ETF Trust SPY, that’s also a danger.

To understand the danger, listen to Francois Rochon, a veteran private client money manager north of the border in Montreal. In a fascinating letter to clients, the founder and CEO of Giverny Capital warned them to beware of the “index” waltz. “

Here’s how it works. You start with a few large-cap stocks that are booming, leaving the rest of the market behind. That’s what we’ve seen over the past year, and it’s changing with the so-called “Big Seven” tech stocks: Nvidia, Apple AAPL, Amazon AMZN, Google parent Alphabet GOOG, Facebook parent Meta META, Microsoft MSFT and Tesla and TSLA. Last year, they contributed the lion’s share of the S&P 500’s performance. Today, these seven stocks alone account for nearly 30% of the entire index’s total value.

When a few big stocks eclipse the market, what happens to the rest of the fund industry? They’re starting to look really bad. Any fund manager who didn’t own those stocks or held more reasonable weightings, Rochon said, woke up to find they were “underperforming and many clients moved to index funds.”

This has been a story for a long time.

These managers, like most people, respond to the incentives offered to them out of self-interest. Rochon noted that these desperate purchases “drove these stocks to new highs,” which in turn made other fund managers who stayed on the sidelines look worse. So they finally gave in and rushed to buy stocks that were booming. Large capacity.

This is a vicious cycle. (Or a virtuous cycle, if you happen to own the right stocks.)

This may be where we are now. It is worth noting that ordinary American investors are now pouring into the stock market after experiencing the bear market in the previous two years. According to the Investment Company Institute, the trade group for the mutual fund and exchange-traded fund industries, investors have bought $73 billion worth of U.S. stock funds since the latest market boom began around Halloween, including in March alone. $45 billion was purchased in the first three weeks 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 anything that can’t last forever won’t last forever. Sooner or later, the concert of this “exponential waltz” ends. We’ve seen this in previous manias. None of the 10 largest companies in the S&P 500 50 years ago are still around today. There it is today. No. Ah yes, those Kodak, Sears and Xerox stocks! good time. There’s no way those companies could fail, right?

Luo Xiong’s point is not that investors should exit the stock market, but simply that they should temper their excitement about some of the market’s biggest stocks. Rochon is a so-called value investor and a follower of the late Charlie Munger. He staunchly attempted to time the market, arguing reasonably that no one could predict the next short-term move. But he must know what he’s doing, because his U.S. stock picks outperform the S&P 500 by an average of 3.9 percentage points. The year span exceeds 30 years.

Meanwhile, the latest frenzy is particularly focused on large-cap growth stocks, such as the “Big Seven.” Cheaper, less exciting value stocks have been left behind. As a result, the Vanguard Value ETF VUV has significantly underperformed the Vanguard Growth ETF VUG, especially since the frenzy around artificial intelligence and the Big Seven really took off early last year. For that matter, the same goes for international stocks. Calming down the frenzy doesn’t necessarily mean exiting the market entirely.

Or you can just keep dancing to the index waltz.

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