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Large Caps Loom Large Over Market

As the American economy expanded after World War II, a small group of U.S. large-caps gradually earned the moniker “Nifty Fifty” to denote their elite status as blue-chip stocks.

From the start of 1946 through the end of 1965, the Dow Jones Industrial Average quadrupled in value, catapulting the index towards the once unthinkable “sound barrier” of 1,000. Although that level pales in comparison to the Dow’s current reading above 22,000, at the time it was a big deal.

Many of the companies that comprised the original Nifty Fifty are still industry leaders including Wal-Mart (NYSE: WMT), McDonald’s (NYSE: MCD) and Procter & Gamble (NYSE: PG). Others are still around but have lost some of their luster including General Electric (NYSE: GE), Sears Holdings (NSDQ: SHLD) and Xerox (NYSE: XRX). And believe it or not, at one time stocks such as Simplicity Pattern, Polaroid, and International Flavors & Fragrances were considered too good to pass up, but no longer exist as independent businesses.

The same force that propelled many of these companies higher eventually became their undoing, as their successes spurred competition and innovation that cut into their profits and sent their share prices reeling. That’s the problem with becoming overly dependent on a narrowly defined group of stocks — the paper gains are intoxicating on the way up, but the realized losses on the way down can be even more painful.

We’re seeing signs that the current stock market is at risk of falling into that trap. Investors are pouring so much money into a select group of huge companies that there isn’t any room for disappointment if earnings expectations fall even a little bit short. That’s why this month’s round of quarterly earnings reports may dictate which direction the overall stock market goes for the remainder of this year.

Not only is half of the year’s operating results on the books, but these mid-term reports usually include revised guidance for earnings expectations for the entire year. Based on the price-to-earnings ratio (P/E) for the S&P 500 Index, it appears shareholders remain optimistic that these companies will be able to sustain strong earnings growth, despite the decreasing likelihood of a tax cut or infrastructure spending to boost the economy later this year.

Multiple Personalities

Some historical perspective may be helpful. Over the past five years, the S&P 500 Index has appreciated 75% while the P/E for the index has increased by 65%. On January 1, 2012, the P/E for the index was 15 times earnings; currently, it is estimated at 26 times earnings. The index has traded at an average P/E of about 16 times earnings over the past 70 years.

Consequently, most of the stock market’s recent gain is the result of investors paying more for earnings, and not from an actual increase in profits. To be sure, the current P/E is skewed by enormous earnings multiples for marginally profitable, yet highly valued tech stocks such as Amazon (NSDQ: AMZN) priced at 195 times earnings and Netflix (NSDQ: NFLX) trading at 244 times earnings.

You don’t have to be a genius at math to see the problem. The stock market is currently priced at a P/E roughly 50% above its historical average while the economy is estimated by the Federal Reserve to grow at about 2% annually over the next decade, well below its historical average. That means if a major corporate tax cut doesn’t happen or the government doesn’t start massively spending on infrastructure, there won’t be enough money falling to the bottom line to justify current stock market valuations.

What Goes Around Comes Around

What this may boil down to is a very expensive game of musical chairs. Companies priced at moderate earnings multiples that remain profitable will attract investor capital, while those that are priced at a premium to the market and come up short on earnings will see their share prices take a beating as investors abandon them in favor of more reasonably priced stocks.

That means a company like Apple (NSDQ: AAPL) that trades at 18 times earnings should hold up well during a stock market correction, but Facebook (NSDQ: FB) priced at 41 times earnings could see some runoff. At the same time, there may be some unexpected winners in sectors currently out of favor such as energy stocks, automobile manufacturers, and retailers, since many of them have been driven down to bargain basement prices.

As the second half of this year unfolds, keep an eye on earnings reports from today’s generation of Nifty Fifty stocks, to see which way the stock market is likely to head.

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