Is the Stock Market a Popularity Contest or a Scale?
If one of your New Year resolutions is to beef up your knowledge around the stock market, today’s blog post is for you! We take a look at the United States financial market and whether a popularity contest or scale is a better description.
The father of value investing Benjamin Graham explained, in somewhat dated terms, that in the short run the market acts like a “voting machine” or as a popularity contest. Companies are valued largely based on sentiment often ignoring fundamental metrics of a company. In the long run, the market operates like a “weighing machine” or a scale, assessing the substance of a company.
One example of this in today’s market is evaluating the five largest holdings in the S&P 500 Index: Microsoft, Apple, Alphabet, Amazon and Facebook. These companies are the most heavily weighted in the index not because someone is choosing them based on fundamentals, but because they are the largest by market capitalization. Their stock prices have been driven higher as more people have purchased shares; they have received the most votes.
So, which companies are receiving the least votes at present? Energy companies. The energy sector currently has the lowest overall price-to-earnings ratio of the entire index at 12.8x earnings. This compares to the information technology sector that has an overall PE of 24.9x. Microsoft—the largest holding in the S&P 500—is worth $1.2 trillion. The entire energy sector consisting of 134 companies is worth $1.1 trillion. Clearly Microsoft is very popular right now and energy companies much less so.
Technology companies have been growing revenues and earnings at faster rates than energy companies since the past recession. Energy companies are facing headwinds such as low oil and natural gas prices and a decrease in demand growth. So, do the markets have this right at present? Benjamin Graham might say, time will tell, which isn’t extremely helpful when trying to decide where to invest today.
At Johnson Bixby, we take a balanced approach to this issue. By consistently monitoring investment portfolios, we take steps to help ensure they have not gotten overexposed to more expensive parts of the market. If so, portfolios can gradually be repositioned to less expensive asset classes. This is not an all or nothing solution, but a measured approach that can help portfolios perform well and remain diversified as the votes are coming in and after they are fully weighed based on fundamentals.
Past performance and dividend rates are historical and do not guarantee future results.
Investing involves risk, including risk of loss. Diversification does not ensure a profit or guarantee against loss.
Information presented herein is for discussion and illustrative purposes only and is not a recommendation or an offer or solicitation to buy or sell any securities. Views expressed are as of the date indicated, based on the information available at that time, and may change based on market and other conditions. Unless otherwise noted, the opinions provided are those of the authors and not necessarily those of KMS or its affiliates. KMS does not assume any duty to update any of the information.
Written By Lynn Snyder, CFA