After briefly being anointed king of the stock market, Nvidia has been hit hard. While that could be a warning sign for investors concerned that this year’s rally has relied too heavily on a few big tech names, there are many ways to avoid bubble-like prices while staying broadly invested.
Last Tuesday, Nvidia briefly passed Microsoft as the most valuable company in the world. Since then, investors have turned to the chip maker for artificial intelligence, sending its shares down nearly 13% over the past three trading days.
Nvidia’s woes aren’t just a potential problem for AI evangelists. Nvidia and other members of the so-called Magnificent Seven club of technology stocks have captured a large share of the overall market gains in recent years. Technology stocks now have a roughly one-third weighting in share prices
S&P500,
compared to less than 25% in 2019.
Nvidia’s valuation (it trades at around 70 times earnings) suggests the stock could fall further. While the price-to-earnings ratios for other tech names that dominate the market aren’t as extreme, those stocks are also richly valued. Shares from which the
Technology Select Sector SPDR
exchange-traded funds trade at 29 times earnings, well above the broader market’s 21 times, according to Morningstar.
For investors, the combination of large index weightings and high valuations poses a risk. If traders were to suddenly abandon big tech stocks, the weakness in that sector alone could be enough to trigger a bear market, notes independent Wall Street researcher Jim Paulsen.
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“The infamous Mag7 (and perhaps a handful of other notables) have risen dramatically in price and if they collapse – due to their excessive weightings – the S&P 500 Index could suffer a decline of more than 20%,” he writes.
Fortunately, Paulsen also notes, there is a silver lining in the top-heavy nature of the market. While Nvidia and other top tech stocks have been on the rise, many corners of the market – including commodities, industrials and consumer discretionary stocks – have lagged. They have achieved average annual returns in the low to mid-single digits in recent years.
“Typically, when the S&P 500 is expanded and overbought, most stocks within the index have enjoyed significant bull participation and the S&P shows widespread vulnerability to a bear,” Paulsen writes. “However, in today’s Bull market, the concentration has been so intense that most stocks have not participated excessively, making the Bear’s job much more difficult.”
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Current price-to-earnings numbers reflect this dynamic, giving investors wary of valuations like Nvidia plenty of opportunity to bet on the stock market without getting into a froth. Consider the Invesco S&P 500 Equal Weight ETF, which owns roughly an equal amount of all the stocks in the index, rather than matching the weights of the stocks to their market value, as the S&P 500 does.
The fund’s allocation to technology stocks is a significant, but not overwhelming, 16%. The portfolio trades at 18 times earnings, a hair below the market’s long-term average of 19.
Small-company stocks, which have lagged large-company stocks for eight of the past 10 years, are a different approach. The
iShares Russell 2000 ETF
is even cheaper: the shares it owns trade at just 15 times earnings on average.
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To be fair, betting on underperforming stocks means investors may be missing out on some of the big tech sector’s AI-powered momentum. But if sentiment changes, the market is much less likely to punish stocks whose prices seem easily justified by their quarterly profits.
It could save investors a lot of pain.
Write to Ian Salisbury at ian.salisbury@barrons.com