Will You Be Able to Break the Cycle?

Hey John,

“This time is different.”

We hear that a lot in the financial markets. Today, that means the notion that the New Economy is resistant to recessions.

That was right before technology stocks lost nearly 80% of their value.

Green Shoots are growing, and the economy is like Goldilocks… not too hot, not too cold.

Not sure if you remember… this view predominated just months before the biggest financial crisis in modern history.

Well, there is one thing that will be different this time.

In the next crisis, there will be nowhere to hide.

A decade of bailouts and easy credit has the markets awash with cash. And this record bull market has brought everyone along for the ride. That means everyone has a long way to fall.

Consider the differences between prior market tops and today’s highs.

Back in the early 1970s, the top 10 stocks represented 34% of the S&P 500. That remains the highest level in 46 years.

By far.

This was a period coming off the “Nifty 50” phase of dominant, must-own growth stocks. These were stocks you could buy and hold forever – in theory. Those unfortunate to have a portfolio of Nifty 50 stocks got decimated in 1973-74.

They never recovered.

Then, energy stocks blew up when they represented nearly 30% of the S&P 500 by the early 1980s. An oil glut saw the price of oil shaved by about two-thirds in real dollars.

Investors bet wrong again.

By the late 1990s, the Nifty 50 was a distant memory. So, like humans typically do, they failed to learn from the past and subsequently worked themselves into a lather over Internet and technology stocks, which represented 33% of the S&P 500.

That was over four standard deviations from the norm.

You don’t need to be a math major to know that is way outside what could be reasonably expected or sustained.

The dominance of technology stocks hid the fact the bear market lurked in other sectors. By the time the tech sector crashed, many stocks were rebounding. If you avoided technology stocks in 2002, you likely did quite well. You might’ve eked out a positive return despite the market taking a beating.

By the time the financial crisis unfolded, banks were in the limelight and represented over 20% of the index, nearly double the historical average.

Once again, many stocks bottomed before the indexes, setting up a powerful rally in 2009 and beyond.

So, where are we today?

Well, the top 10 stocks don’t dominate the market.

At 20%, they’re below the long-term average of 22%. The technology sector is back up there at 26%, driven by a few companies leading the way. Financials have reverted to the mean.

Lastly, energy is nowhere to be found. The hard-hit sector ranks seventh out of 11 sectors.

The big difference today is just how high the entire market is priced.

The median price-to-sales ratio of the S&P 500 is 2.48x.

Simply put: We’re sitting near all-time highs. And, again with the fancy math, that’s about three standard deviations above normal.

Everything is overvalued.

A little-know indicator confirms this.

When the price of the lowest 25 stocks in the S&P 500 is low in dollar terms, it’s time to snap them up as bargains.

Think about it: In a bear market, many stocks get brutalized that don’t deserve it. Their stock prices fall $3 to $4 or more – only to rebound when the “All Clear!” siren sounds.

This is how John Templeton made his first fortune. Today, the 25th-cheapest stock in the market is $22.60, an all-time high. When these stocks trade below $6 a share, the annual returns are over 25%.

Always remember that the market is inherently speculative. Now, everything has been bid up to nosebleed levels.

When (not if) things turn, it’s highly likely that the vast majority of stocks will take a beating, unlike the last several bear markets.

Good luck out there,

Originally appeared in The Rich Investor