By Kyle Tetting
As an investor in stocks, it pays to be an optimist. That’s easy to say as the Dow Jones Industrial Average recently traded above 40,000 for the first time. But perhaps some of the optimism is lost amid already-strong returns. Add in the general unease among consumers and a host of geopolitical concerns, and Dow 40,000 may not tell the whole story.
In fact, the Dow’s records actually understate my optimism for the road ahead.
For starters, the Dow’s not a great representation of the opportunity for stocks. As of this writing, the 30-stock Dow was dominated by names like UnitedHealth Group, Caterpillar, Home Depot and McDonalds, accounting for nearly 25% of the price-weighted index. Those are strong American businesses, to be sure, but not a good representation of the U.S. economy or of the market broadly.
Arguably, the S&P 500 is just as concentrated, but it’s much more representative of the businesses at the forefront of innovation. Of the top 10 names in the S&P 500 – accounting for roughly a third of the index’s market cap – just four are represented in the Dow: Microsoft, Apple, Amazon and JPMorgan Chase. Missing are the likes of Alphabet, Meta, Berkshire Hathaway and, perhaps the most relevant, Nvidia.
Every measuring stick is flawed, but the Dow seems increasingly irrelevant.
While the Dow captured headlines in May, more appropriate benchmarks like the S&P have also been flirting with highs in recent months. But that shouldn’t trigger fears that stocks have peaked. Studies suggest stock returns tend to be stronger than expected following market highs.
In one such study, the average return in the 12 months immediately after the market hit a record high is nearly 20% better than investing at all other times. Good times tend to lead to more good times or, maybe, let the good times roll.
There’s a host of reasons why that may be true, but the most likely is that the general direction for stocks is higher. The average annual total return for the S&P 500 from 1950 through 2023 was 11.4%. The spread of returns from year to year is significant with many down years in that time, but historically, stocks have gone up.
A second set of circumstances may speak to what drives the underlying stock returns at this moment.
Strong returns tend to coincide with a strong economy and strong corporate earnings. Those conditions have shifted quickly on occasion, but in general, economic growth tends to feed on itself in a virtuous cycle. Consumers feel emboldened to spend because of strong economic gains, which further drives strong economic gains.
Historical context is great, but it says nothing of the specific confluence of factors that drive my optimism for stocks beyond the current conditions. Specifically, I am hopeful because of high levels of cash, generational technological shifts and a stable economic backdrop.
Cash
First, investors have stockpiled more than $6 trillion in cash, a doubling in just six years. Similarly, non-banking U.S. businesses now sit on $6.9 trillion in cash. High interest rates and risk management appear to be two key reasons for large cash balances. With recent strong returns in stocks and the potential for falling interest rates on the horizon, investors and businesses alike are reassessing the best use of their reserves.
Technology
Which leads to opportunities in a once-in-a-work-life shift in technology. The increasing pace of adoption of automation, artificial intelligence and robotics in the workplace will likely lead to continued productivity gains the likes of which we haven’t experienced since the broad adoption of the internet.
Investors are forced to choose between the likelihood of declining rates in cash or the potential gains in earnings driven by more profitable businesses. Similarly, those businesses with cash are left to weigh capital expenditures that might help drive future growth vs. continuing to sit on piles of cash. Notably, the businesses best positioned for investing in growth are the larger components of the S&P 500, some of which aren’t represented in the Dow.
Economy
Finally, none of these outlooks are possible in a volatile economy. Businesses concerned about declining revenue or consumers worried about layoffs have difficulty committing the large capital outlays necessary to expedite significant change. Fortunately, despite some bumps along the way, the U.S. economy has proved incredibly resilient the past few years.
It should surprise no one that despite my optimism in the opportunities ahead for stocks, I find the path for a balanced portfolio even more attractive. Historical context tells us that at a certain point, you aren’t appropriately compensated for the risk of increasing your stock exposure. But beyond that, it remains difficult to ignore high yields in cash or the improved outlook for bond investors.
Kyle Tetting is president of Landaas & Company, LLC.
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(initially posted May 31, 2024)