Bill Smead got straight to the point in his latest letter to investors when characterizing how overextended stocks are.
“This financial euphoria episode has gone to a sustained high that makes the dot-com bubble look like small change,” he wrote in the August 22 letter. Smead is the founder of Smead Capital Management and comanages the Smead Value Fund (SMVLX) with his son, Cole. The fund is beating 99% of similar funds over the last five years, and 98% over the last 10- and 15-year periods. Since March 2020, the fund has returned 121%, crushing the S&P 500’s 91.6%.
So, why the bold claim? Smead pointed to extreme concentration in tech stocks. So far this year, just seven tech stocks have driven a majority of the S&P 500’s impressive returns. Year-to-date, the index is up 15.5%, but that number reached as high as 20% at the end of July.
One way the concentration is apparent in the tech sector is by looking at the performance of the tech-heavy Nasdaq 100 index compared to that of the Russell 2000, which is viewed as a small-cap index. Taking the Nasdaq 100’s current level around 14,965 and dividing it by the Russell 2000’s level of 1,861 produces a quotient of 8.04. The high during the dot-com bubble was 8.16. But while the ratio hovered above seven in the year 2000 before falling down near to two, it’s risen to seven again in 2020, 2021, and 2023.
Another way to characterize the concentration is by looking at the share of market value of the S&P 500 that the tech sectors has. At the height of the dot-com bubble, it went above 34%. Today it’s at 28%. But if you add firms like Amazon, Tesla, and Netflix — which could arguably be considered tech companies — and Alphabet, Meta, Visa, Mastercard, Paypal, and Fiserv — which were once considered to be in the tech sector — that number is above 41%, Smead said.
And then there’s investor psychology. Household equity ownership — or the percentage of household assets that are held in equities — is above 35% and near levels seen during the dot-com bubble. This gauge has a 0.82 correlation coefficient (the highest coefficient possible is 1) with annualized stock market returns over the following 10 years. Household equity ownership over 35% is consistent with just about 0% annualized returns over the next decade.
But that’s on average. Don’t take that to mean the S&P 500 will deliver low returns every year until 2033. It’s more likely stocks see a bigger sell-off in the coming years.
“Few things in this life are certain. However, after 43 years in this business, there is one thing we find empirically true throughout history. Manias die in vicious ways,” Bill said in the letter to investors.
On a phone call with Insider on Friday, Cole said he believes the S&P 500 will shed 30% of its value or more in the coming years. He thinks this will end up with investors being disillusioned with stocks for years to come.
“The psychology is very bad. People are very complacent,” Cole said. “You do not clean up psychology without damaging people’s souls.”
Stocks have enjoyed a renewed bull market this year thanks to hype around artificial intelligence and growing optimism that the US economy will be able to avoid a recession after all.
How long that this optimism remains, however, is uncertain. The S&P 500 is down 4% this month as interest rates rise due to investor fears about further Federal Reserve hawkishness amid a resilient labor market and strong economic growth that could keep inflation elevated.
And while the economy is strong at the moment, the longer the Fed keeps rates elevated, the higher the chance a recession strikes.
Dubravko Lakos, the top global stock strategist at JPMorgan, told CNBC this week that he sees a recession ahead as inflation stays higher than the Fed’s target of 2% and rates stay higher.
“I think there is no landing, no landing, until you get to hard landing,” Lakos said. “I don’t buy into the soft-landing thesis.”
Leading macro indicators like the Treasury yield curve and The Conference Board’s Leading Economic Index point to a recession ahead. Both have perfect track records of producing recession warnings over the last several decades.
Some argue that this time is different, with consumers still spending thanks in part to pandemic stimulus and inflation having already moderated significantly.
But time will tell if that turns out to be true as the lagged effects of high interest rates continue to work their way into the economy.