Investor Heuristics vs. Economic Reality, 6/9

I see them colliding

UPDATE: The macrotrends chart that I used as a data source is wrong for Amazon. Better numbers are now in the table.

As you know, I am on the bearish side of the stock market tug-’o-war. Recently, I have talked to ordinary individual investors who are on the other side. Here are some of their heuristics:

• “In the long run, stocks are a great investment. Declines happen, and you just have to push through them.”

• “I don’t try to time the market. I just keep adding to my 401(k) every month”

• “I am like Warren Buffett. He says to be fearful when others are greedy and greedy when others are fearful. Others are fearful now, and Buffett is buying”

• “I go with the gospel according to Vanguard. Just buy and hold an S&P 500 index fund.”

These heuristics are used to justify buying stocks. When stocks reach a new high, buyers trot out “I don’t try to time the market.” When stocks decline, they trot out “I am greedy when others are fearful.”

I try to interpret economic reality. The scale of the entire U.S. economy is measured by nominal gross domestic product, or NGDP. In 2014, it was $17.5 trillion. In the first quarter of this year, the annualized NGDP was $24.4 trillion.

Compare this with the market capitalization of what used to be known as the “FANG” stocks: Facebook (now Meta); Apple; Amazon; and Google (now Alphabet). I obtained charts of market cap for these stocks from the web site macrotrends.net, pulling out the values as of June 2, 2014 and May 30, 2022.

Market capitalizations, in billions

stock               2014          2022
Facebook      $160.0       $519.9
Apple             $554.5      $2366.6
Amazon*        $120.0      $1170.0
Google          $375.6       $1512.6

Total             $1210.1     $5569.1

*Amazon chart on macrotrends seems wrong. Data approximated from https://companiesmarketcap.com/amazon/marketcap/

The total market value of these four stocks can be compared to the size of the economy. In 2014, we compare $1210.1 billion to $17.5 trillion. For every $1000 of NGDP, there was 1097.7/17.5, or $69.1 of market cap. In 2022, this ratio was 4461.4/24.4, or $228.2 of market cap per $1000 of NGDP.

In eight years, these four stocks just about tripled in value relative to the scale of the economy. That will never happen again. Never. Happen. Again. Even if their stocks appreciate in value, the rate of increase is bound to be lower than it has been. At this point, there is not enough room for profits to increase sufficiently to again triple the ratio of market capitalization of these firms relative to NGDP.

The other economic reality that investor heuristics ignore is that the current configuration of interest rates and inflation is unsustainable. In my view, the path of interest rates contemplated by the Fed—and by the markets—will leave rates too low to bring inflation under control.

The tug-o’-war model says that there must be people with the opposite view of mine. That is, there must be people who think that the path of interest rates is too high, and that rates will turn out to be lower than expected. I cannot see that happening without a recession, and a recession would hurt profits and stock prices.

I think that the right way to value stocks is to consider scenarios for interest rates and corporate profits. The investor heuristics have nothing to do with these fundamentals. If we can take it as given that the fundamentals are not out of line, then the heuristics will work well. But in recent years, those heuristics have pushed stock prices far above the values that are consistent with economic reality as I see it.

I may have the wrong picture of the economy. Perhaps low interest rates are more sustainable than I believe to be the case. Or somehow the large-cap companies can take a significantly larger bite out of the economy. All I can say is that as of now investor heuristics and my view of economic reality are on a collision course.