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October 24, 2024

Goldman’s Bleak Outlook for Mega Caps

Wall Street is littered with strategists and forecasters offering finely tuned projections as to where the stock market is headed. So long as human beings have a desire to know what the future holds, Wall Street— like the palm reader around the corner—will be there, selling answers.

Generally speaking, the stock market as a whole tends to rise over time. Market-based systems basically work, which means investors in risk assets like stocks tend to get compensated for taking on risk.

The S&P 500 Index has, in fact, delivered a compounded annualized return of approximately 10.7% over the past 20 years. This outcome exceeds typical assumptions for long-term stock market returns, which are usually closer to 8%. Stock market investors have endured a few crises along the way but have been rewarded handsomely for their persistence.

Based on historical experience as well as financial theory, stocks as a whole should also over time outperform government and investment-grade bonds, which are normally less volatile. Stocks are riskier, therefore investors in stocks should be rewarded with what finance professors call the “equity risk premium.”

While the stock market has an upward tendency, the path can be rocky and extremely hard to predict. That of course does not deter people from trying to predict it.

At any given moment, you will be able to find a market forecaster predicting a crash, predicting a bubble, or something in between. Like a broken clock twice a day, sometimes they even get it right.

What makes timing the market so difficult is that markets are highly unpredictable and market-moving events are often random. Many of the most successful professional investors therefore view market-timing as a bit of a fool’s errand.  

We've long felt that the only value of stock forecasters is to make fortune tellers look good. Even now, Charlie [Munger] and I continue to believe that short-term market forecasts are poison and should be kept locked up in a safe place, away from children and also from grown-ups who behave in the market like children. - Warren Buffett

We personally prefer to focus our energies on individual investment opportunities rather than broad market forecasts. Occasionally, however, a specific market call gets a lot of attention in the press and piques our interest.

Recently, David Kostin, who holds the highly prestigious title of Chief U.S. Market Strategist at Goldman Sachs, has been in the news. Kostin is conveying a relatively downbeat assessment of future performance for the S&P 500, which he predicts will only return 3% annually over the next 10 years.

Noting that the yield on the 10-year Treasury is now approximately 4%, Kostin believes the S&P 500 Index will face “stiff competition” from bonds. His model tells him there is a “72% chance” that the S&P 500 Index will underperform Treasury bonds over the next 10 years. That would be lousy.

Concentration risk

What stands out in Kostin’s analysis is the primary reason he thinks the S&P 500 will perform badly: “concentration risk.” Market concentration refers to the fact that a small number of highly valued companies now have, by historical standards, a disproportionate impact on the capitalization-weighted index.

The intuition for why concentration matters for long-term returns relates to growth in addition to valuation. Our historical analyses show that it is extremely difficult for any firm to maintain high levels of sales growth and profit margins over sustained periods of time. The same issue plagues a highly concentrated index. - David Kostin (10/22/2024)

Kostin explained in a recent social media post that his model would indicate a 4% uplift in future S&P 500 returns if not for the excessive concentration of the index. This would bring his baseline forecast closer to a 7% expected return, which aligns with typical expectations.

He goes on to note that “the S&P 500 equal-weight benchmark (SPW) is likely to outperform the cap-weighted aggregate index (SPX) during the next decade by an annualized 200 bp-800 bp.”

What he is referring to here is the idea of investing in a version of the S&P 500 that equal weights all the stocks in the index, which can be done through an ETF like the Invesco S&P 500 Equal Weight ETF (RSP).

He believes an investor in the equal weight index could potentially expect to get as much as 8% higher returns per year. Given his 3% forecast for the market-cap weighted index, this translates to 11% annually.

Implicitly, Kostin is predicting very bad returns for the largest market cap stocks in the index over the next 10 years—potentially zero or negative. In other words, he thinks stocks like Microsoft (MSFT), Apple (AAPL) and NVIDIA (NVDA), which have dramatically outperformed the index and been among the key drivers of market returns over the past 10 years, will create little to no value for investors for many years to come.

Our reaction

Setting aside his methodology and forecasts, Kostin is right to place emphasis on market concentration as a crucial variable that could affect stock market returns.

As we have noted on many occasions, the S&P 500 Index is now dominated by a handful of Mega Cap stocks, which in some cases have multi-trillion dollar valuations. These include the widely discussed Magnificent Seven tech platform stocks, which now represent about one-third of the index.

After considering Kostin’s thesis, we have a few main takeaways.

(1) The S&P 500 Mega Caps do carry unique risks.

The Mega Cap names at the top of the S&P 500 holdings list trade at much richer valuation metrics relative to most other stocks. Currently, on an equal weight basis, the Magnificent Seven trade at approximately 34x estimated 2024 earnings. The market-cap weighted S&P 500 trades at 24x. The equal weight S&P 500 index trades at 19x.

Almost all of the top 10 holdings within the market-cap weighted S&P 500 Index (representing approximately 35% of the index as of 9/30/2024) are technology or technology-related. Buffett’s Berkshire Hathaway (BRK) is the lone exception. The Mega Caps therefore do not offer a high degree of sector diversification and are generally tied to the same themes, such as the ability to create value through investments in AI.

Source: SPDR S&P 500 ETF Trust (9/30/2024)

We agree with Kostin in that it makes a great deal of sense to consider the disproportionate impact of these highly correlated stocks. An investment in an S&P 500 Index fund or ETF is indeed to a large extent now an investment in a small number of tech-related businesses.

(2) We are not convinced of Kostin’s backward-looking approach.

Kostin’s bleak outlook for the Mega Caps appears to be largely based on historical performance of similarly highly valued securities. While we do not know the inner workings of his valuation model, the rich financial metrics associated with these tech leaders appear to be their most important drawback.

He also appears to be skeptical of the ability of any company to sustain high growth rates for an extended period of time. This represents a “reversion to the mean” type of assumption.

We question the usefulness of thinking about all of these stocks in aggregate and applying historical patterns that may be more relevant to companies outside the technology space.

The key question is if each of these stocks truly deserves the elevated valuations the market is now applying. A good answer to that question can really only be generated on a case-by-case basis.

Just because a stock trades at a high earnings multiple and has delivered high growth rates for many years, this does not mean it is overvalued and likely to perform poorly. Companies with strong economic characteristics (customer captivity, structural growth, innovation opportunities) deserve to trade at high multiples.

At the same time, rich valuations imply high expectations. The Mega Caps do need to deliver on already high expectations for earnings growth.

If growth comes in below expectations, there is a lot of room for “multiple compression.” If investors are disappointed with growth, they might, for example, reprice a stock from 35x earnings to 25x earnings, which implies approximately 30% downside.

(3) Investors should not abandon the Mega Caps… but it makes sense to look for individual opportunities elsewhere.

Kostin may or may not be correct in his dim outlook for the Mega Caps of the S&P 500. On the one hand, they are highly valued. On the other hand, they are among the most successful businesses ever created and dominate their respective niches in the economy.

The vast majority of stock market investors have broad-based index exposure through passive funds that mirror the S&P 500, the Nasdaq 100 or global indices like the MSCI ACWI (where U.S. Mega Caps also have a dominant presence, albeit somewhat diluted by foreign stocks).

Having a high permanent allocation to passive, low-fee, market-cap weighted funds within an individual portfolio represents conventional financial advice. It also makes a lot of sense. This approach has certainly worked well over time (to the frustration of the active fund management industry).

As investors look to diversify their portfolios away from highly concentrated index funds, however, it stands to reason that they should focus on opportunities other than the highest weighted index names.

Using our Model Portfolios

Within all three of our Model Portfolios, we have made a deliberate decision to emphasize stocks that are not heavily weighted within most indices. None of our Model Portfolio stocks currently represent more than a 1% allocation within the S&P 500, and none of them are top 10 S&P 500 Index holdings.

While the outlook for Mega Caps may or may not be as grim as Goldmans’ strategist suggests, as a group they are richly valued on a relative basis and tend to be highly correlated within one another. These are in many respects extraordinary companies, but stock pickers should consider looking beyond this small handful of widely-owned names, especially if they already have a great deal of exposure to them.  

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