The dramatic outperformance of NVIDIA and other Big Tech is based upon the belief that Generative Artificial Intelligence is a transformative technology. Some claim it will be on par with the impact of the internet. They may be right. Our own first interactions with ChatGPT had the same feelings of wonder as, ahem, opening a Netscape browser or AOL portal circa 1996. [i]
However, technological breakthroughs and advancements are part of the human experience. Indeed, we have witnessed four other distinct transformative technologies in our lifetimes (as described by Aswath Damodaran, a Professor of Finance at the Stern School of Business at New York University):
After personal computers in the 1980s came the dot-com boom and the internet revolution in the 1990s, followed by smartphones in the 2000s, which facilitated the explosion of social media in the 2010s. The defining feature of these developments was not just that they affected broad swaths of business – sometimes positively, sometimes adversely. It was that they fundamentally changed how we live, work, and interact. [ii]
Invariably, these new technologies bring initial excitement and rapid gains to the stock market. But, over the longer term, they have little effect. As Damodaran noted, the returns of the S & P 500 during the last four decades of multiple transformative technologies was very similar to the return of the stock market over the previous four decades (1940-1980). The S & P 500 from 1940-1979 advanced at 10.4% per annum versus 12.0% annualized from January 1980 through May 2024.
Two additional comments on these returns. The 12% annualized S & P 500 return since 1980 was driven substantially by declining bond yields and corresponding rising stock market valuations. Further, the 12% annualized return masks the “Lost Decade” of the 2000s where the S & P 500, dragged down by the tech bubble and global Financial Crisis, lost 1% per annum. [iii]
The lesson? Let’s not get carried away and let recent gains influence us to chase returns and shift allocations towards equities.
But what about within the stock market? The runaway outperformance of a few large market leaders can have an outsized effect on stock market indexes. As a company’s price rises, so does its weight in the index. NVIDIA went from being the 85th largest holding in the S&P 500 to 3rd as of the end of June 2024. [iv] (It briefly was the largest holding on June 18.) As it continued to outperform it had a larger and larger impact on the return of the S & P 500.
But there’s the rub. The S & P 500 weights each stock on their market capitalization, which is the total price for the entire company. The concentration in NVIDIA (and other AI beneficiaries like the Magnificent 7) have risen substantially *after* their material price runups. If they are in a bubble today (or merely overvalued), the index fund has maximum exposure at the peak! Some compare NVIDIA to Cisco, the internet darling of the late 1990s, that subsequently crashed. Indeed, the technology sector dragged down the S & P 500 to the aforementioned Lost Decade of the 2000s. Like 1999, the S & P 500 is trading at a very high multiple today, ranking in the 97th percentile of historical P/E ratios. [v]
What will happen this time? Will history repeat and we undergo another lost decade? We don’t know…and neither do the market pundits predicting a market dragging crash in AI stocks.
While we’re not big on predictions, we do emphasize preparation. But how? Our baseline equity allocation blends market capitalization weighted indexes like the S & P 500 with fundamental weighting, a strategy seeks to break the link between a company’s price and its portfolio weight. [vi] By construction, it tamps down stocks whose prices have materially outpaced their fundamentals. The resulting portfolio is designed to avoid much of the concentration we see in bull market extremes.
However, if it reduces exposure to recent winners, won’t fundamental weighting miss out on major transformative technology companies? It does. So should we expect it to produce lower returns. We should not. Over the aforementioned four-decades-plus period of transformative technologies, a fundamentally weighted portfolio would have outperformed the S & P 500 by 1.2% per annum. According to data from Research Affiliates, a fundamentally weighted portfolio of US Large companies produced an annualized return of 13.2% versus 12.0% annualized return of the S & P 500.
How could that be? First, the market may get ahead of itself on the economic effect big of the transformative technology. This was certainly the case of the Internet bubble of 2000, where fundamental weighting would have sidestepped much of the carnage. Second, the seeming market leaders often didn’t last long. Damodaran explained that it took considerable time for both consumers and businesses to embrace and optimize the technology. Our Commodore 64 computers, AOL accounts, Blackberry devices and MySpace pages can attest! Products and business models had to evolve from value creation to value capture. With these evolutions, the market had fits and starts in sorting out the eventual winners. Venture capital investor David Cahn of Sequioa Capital (no slouch when it comes to funding transformative companies) recently explained, “…a lot of people lose a lot of money during speculative technology waves. It’s hard to pick winners…” [vii]
The lesson? You don’t need to chase the returns of transformative technology stocks to achieve long-term success.
Prudent stewards of wealth understand that game changing technological advancements occur from time-to-time. While they may fundamentally shift how we work and interact, they are unlikely to materially impact long-term stock market returns. Further, investors need to remain disciplined within their stock market exposures, relying on strategies that can do well in when markets are trending up and when trends eventually reverse.
[i] We tell our teenagers that and they look at us like we grew up without indoor plumbing!
[ii] https://www.project-syndicate.org/columnist/aswath-damodaran
[iii] For more on the so-called Lost Decade (including how the diversified investor could have sidestepped much of it), see the following link from John’s Research Affiliates days. https://originpreprod.researchaffiliates.com/content/dam/ra/publications/pdf/F_2010_Jan_The_Lost_Decade.pdf
[iv] NVIDIA is crucial to AI because its advanced GPUs power the high-performance computing needed for efficient machine learning and deep learning processes.
[v] See Research Affiliates Asset Allocation Interactive at https://interactive.researchaffiliates.com/asset-allocation#
[vi] It does so by using fundamental measures like sales, cash flow and dividends to determine weights. As an example, suppose Company A had $100 in sales as compared to $2,000 in sales for all of the companies. The sales weight for Company A would be 5% (or $100/$2,000). We then can repeat the exercise for cash flow and dividends. Suppose Company A’s cash flow was 4% of the total cash flow of all companies and its dividends were 6%. Its combined fundamental weight would be 5% (5% + 4% + 6% divided by 3.) Fundamental weighting then periodically rebalances back to this target. For more than you’ll ever want to know about the strategy, please see The Fundamental Index: A Better Way to Invest (Arnott Hsu and West, 2008).