“The most contrarian thing of all is not to oppose the crowd, but to think for yourself.”
~ Peter Thiel
Market Returns & Outlook
First, at the time of writing, both the S&P 500 and the NASDAQ indexes reached record highs. June YTD returns of the major indexes tracked by Trajan Wealth are illustrated in the table below.
With that said, every year, the financial columnist John Authers of Bloomberg publishes a jocular annual report of an imaginary investment firm called Hindsight Capital, which, as Mr. Authers describes, “is the most successful hedge fund of all time and uses the one strategy guaranteed to beat all others, all of the time; hindsight. The firm places its trades in full knowledge of how they will end up.”i Unsurprisingly, Hindsight Capital delivers consistently superlative returns.
Unfortunately, we can’t replicate Hindsight’s strategy by going back in time and investing all your capital in the “Magnificent Seven” (Apple, Amazon, Microsoft, Meta, Alphabet, Nvidia, and Tesla) at fractions of their current valuations. Hindsight is a useful tool insofar as we can learn from history. Without the aid of time travel, however, extrapolating solely from hindsight can lead towards a risky approach for evaluating investments and deciding on asset allocation.
| Index | 2Q YTD TR (%) | June, 2024 |
|---|---|---|
| US Large Cap – S&P 500 | 15.29% | 3.59% |
| US Large Cap – Tech Heavy NASDAQ | 18.57% | 6.03% |
| International Equity – MSACWI ex US | 5.69% | (0.09)% |
| US Small/Mid Cap – Russell 2500 | 2.34% | (1.50)% |
| Bloomberg Aggregate Intermediate Bond Index | (0.71)% | 0.95% |
Magnificent Seven YTD Returns & Current Valuations
| Stock | YTD Returns (7/5/2024) | Price Earnings (P/E) Ratio |
|---|---|---|
| Apple – AAPL | 17.3% | 35.0x |
| Amazon – AMZN | 31.5% | 54.5x |
| Microsoft – MSFT | 24.7% | 40.4x |
| Meta – META | 51.4% | 27.7x |
| Alphabet (GOOG) | 36.6% | 28.8x |
| Nvidia (NVDA) | 156.7% | 74.0x |
| Tesla (TSLA) | 1.1% | 113.1x |
| S&P 500 | 17.5% | 24.3x |
ii. Source – Bloomberg as of Noon MST 7/5/2024.
That said, extrapolating from hindsight is simple and easy; recent winners are likely to continue winning. There is more than a kernel of truth to this when it comes to markets, as hundreds of billions of dollars in momentum-based trading strategies are based on that simple principle. And beyond momentum trading, there could also be a structural reason that explains why even savvy institutional investors continue to pour in dollars into past winners, irrespective of whether the stocks look “rich” or expensive from a historical perspective and in relation to the overall index. This has much to do with how professional managers are evaluated; the underpinnings of which stems from performance not simply against a benchmark, but also relative percentile rankings amongst peers. To illustrate, consider the “Prisoner’s Dilemma problem” first framed by Merrill Flood and Melvin Dresher at the RAND Corporation. A quick recap…
Game Theory – The Prisoner’s Dilemma Problem
The framework of the Prisoner’s Dilemmaiii is simple. Consider two thieves, A and B, caught in relative proximity with the possessions of a person murdered within the previous 30 minutes. Police thus have evidence against both A and B of theft, a relatively minor crime carrying a sentence of 2 years. A and B are both suspects of murder, a crime that carries a stiff sentence of 20 years, but evidence against either is lacking.
The police authorities take them independently to separate locations and, unbeknown to other, offer each the opportunity to incriminate the other. The reward for cooperating to Prisoner A is absolute clemency if evidence incriminating him for murder is never found, and a reduced sentence of 10 years if evidence were to appear. A similar reward structure is offered to Prisoner B, independently and unbeknown to A.
Notice from the above payoff table that the dominant strategy for both prisoners is to cooperate and incriminate each other. The payoff from remaining quiet for both A and B is either 2 years (charge for the minor theft crime if the counterpart decides to remain quiet too) or 20 years if either one remains quiet but is incriminated by the other – the penal sentence structure essentially boiling down to 2 at best or 20 years at worst. Contrast that to the payoff to both for cooperating – either full clemency if the other remains quiet, or a reduced sentence of 10 years, if the counterpart too cooperates, resulting in a penal sentence of 0 or 10 years. Quite rationally, 0 or 10 years in prison is a preferable outcome for both prisoners than the alternative possibility of 2 or 20 years. Thus, by exercising their respective dominant strategies, both A and B end up cooperating and implicating each other, thereby receiving sentences of 10 years respectively, see the circled 4th quadrant in the above table. The “tragedy” for both prisoners is that had they been able to collude and trust each other, a better outcome would have been possible – neither exercising their dominant strategies by remaining quiet would have yielded 2-year sentences for each prisoner.
Top Holders of Magnificent Seven
| Stock | Top Holders – Institutions/Individuals | Mkt. Cap ($ Trillion) |
|---|---|---|
| Apple – AAPL | Vanguard, BlackRock, Berkshire Hathaway, State Street, Geode Capital | $3.47 |
| Amazon – AMZN | Jeff Bezos, Vanguard, Blackrock, State Street, FMR LLC, T Rowe Price, Goede Capital | $2.08 |
| Microsoft – MSFT | Vanguard, BlackRock, State Street, Capital Group, FMR LLC, Goede Capital | $3.48 |
| Meta – META | Vanguard, BlackRock, State Street, Capital Group, FMR LLC, Goede Capital | $1.37 |
| Alphabet (GOOG) | Vanguard, BlackRock, FMR LLC, State Street, Goede Capital, Capital Group, T Rowe Price | $2.36 |
| Nvidia (NVDA) | Vanguard, BlackRock, FMR LLC, State Street, Huang Jen-Hsun, Goede Capital, T Rowe Price | $3.1 |
| Tesla (TSLA) | Elon Musk, Vanguard, BlackRock, State Street, Goede Capital, Capital Group | $0.80 |
| S&P 500 | N / A | $44.08 |
iv. Source – Bloomberg as of 7/5/2024.
Readers may wonder how the “Prisoners Dilemma” framework is connected to the stellar returns posted by the Magnificent Seven and what explains the continuing upward momentum in stock prices among the companies within this group, despite the high valuations illustrated in table 2.
To answer these questions, we draw attention to the above table. Notice that apart from the founders, the largest holders of these stocks are large, institutional fund managers. Beyond this list, the next 20 holders also represent a “who’s who” list of institutional money managers; among whom the majority deploy “active” fund management strategies, with the twin objectives of (i) beating a (common) benchmark and (ii) jockeying for top peer group rankings in institutional manager databases such as Lipper.
We hypothesize that the extremely competitive marketplace for clients’ assets in part drives much of the buying activity in the Magnificent Seven, even at elevated valuations. Most managers may recognize that the stocks are “rich” by conventional measures, thus limiting the extent of future performance, but dread being exposed against the competition if the upward momentum continues. “Staying invested” in expensive stocks may limit further gains in bull (upward trending) markets if the competition does the same, even generate additional fillip if certain members in the peer group reduce their positions but being the only seller (or one of few sellers) could be catastrophic in terms of peer group rankings. However, if all participants could agree on what constitutes “reasonable value” and collude over exit and subsequent re-entry points, a better outcome could be achieved by all in terms of absolute future performance, if not peer rankings. But alas, security laws, market structure, and Wall Street’s competitive drive make that impossible, leading to periods of extreme crowding in certain sectors of the market.
To be sure, a few of the largest holders of the Magnificent Seven are index replicators, such as Vanguard, rather than active managers jockeying for peer group rankings. But index replication is also a driver of momentum. Their effect in terms of crowding the market is akin to that of the active manager group caught in the Prisoners Dilemma phenomenon of strategic decision making.
Note, crowding is a phenomenon not necessarily exclusive to upward trending environments for the overall market or certain sub-sections of the market. The reverse may also happen. Under a downward trending “bear” markets scenario, extrapolation, the Prisoners Dilemma effect, and the imperatives of index replicators could result in participants continuing to sell assets that may have become “cheap” by conventional measures.
Implications
The point of this letter is not to dismiss the wisdom of the crowd or to argue for being a contrarian just for the sake of being different. Going with the crowd is usually a defensible choice both from an investment standpoint (markets tend to be efficient in assimilating data – the high valuations in the Magnificent Seven may be justified by stellar growth prospects) and from an evolutionary standpoint (there is safety in a herd). We simply want to urge a certain level of caution in taking the simple and easy route with investing right now, as doing so would lead to an extremely narrow set of companies in the technology space. To be clear, we like owning large cap tech companies in our portfolios and have done so for years. Furthermore, we do not expect large cap tech stocks to crash. We just doubt that the pace of share price and valuation gains are sustainable, particularly if economic growth slows and long-term interest rates remain range bound near their currently prevailing levels. As such, diversifying away from highly concentrated positions in the Magnificent Seven may be an appropriate strategy for our clients and prospects.
Recommendations
As discussed in prior letters, we recommend clients with highly concentrated allocations to large cap US equities consider increasing the weightings of fixed income assets in their overall portfolios. This will help dampen unforeseen volatility. For eligible clients, investments in Private Equity, Real Estate, and Infrastructure through limited private partnerships may help further diversify their asset allocations and capture a certain level of uncorrelated returns (alpha) from uncrowded off market deals, and various tax-efficient structures. For help in reviewing your portfolios and making any necessary changes, please call our Portfolio Management Group at (800) 799-3320.
i. Source – John Authers, Bloomberg, A Decade of Markert Wins for Hindsight Capital LLC (December 30, 2019).
ii. Source – Bloomberg as of Noon MST 7/5/2024.
iii. Credit – Merrill Flood and Melvin Dresher at the RAND Corporation.
iv. Source – Bloomberg as of 7/5/2024.
