Most investors want the financial world to exist in black and white.
Tell me when to buy or sell, when to be bullish or bearish, when to buy this stock or avoid that stock, when to go all in or get out of the market.
The market is difficult because most things exist in shades of gray. It's hard to be sure about anything because no one knows what the future will hold and the past can be unreliable if used incorrectly.
Big mega-cap stocks are a great example.
Some believe the concentration of large-cap tech stocks in the U.S. is a real concern.
Some people think it's foolish to bet on the biggest and best companies they've ever seen.
Let's look at both sides of the argument here.
The concentration of major companies is astounding. Look at how quickly things changed at the end of 2015 alone.
The five largest companies (Nvidia, Apple, Microsoft, Amazon, and Google) account for nearly 30% of the total.
The market capitalizations of these companies are also impressive.
Apple, Nvidia, and Microsoft are all $3 trillion companies. Google and Amazon are each worth more than $2 trillion, and Facebook, Tesla, and Broadcom are all in the four-comma club. Berkshire Hathaway's $1 trillion is just a stone's throw away.
These numbers are staggering.
Nvidia is worth more than the market cap of Pluto and Venus combined! Just kidding, these companies are as big as the stock markets of many developed countries, so it's hard to understand.
Investors are worried about all the commonplace topics.
Trees don't grow towards the sky. Size is the enemy of great performance. Nothing fails like success on Wall Street. Price is what you pay, value is what you get.
And yet…
These companies keep getting bigger, stronger, and more powerful.
Michael Chamberrest of JP Morgan In a recent article, I shared the following chart that shows how unique today's top 10 companies are compared to history.
I've never seen a company this big have profit margins like this. These are different from the railroad companies and iron smelting companies of the past, which required large fixed investments in plant and equipment. They are technology companies with more efficiency and scale than your grandfather's mega-caps.
Of course, everyone knows all this now.
You would have to have your head sewn into the carpet to miss the fact that these companies have significantly outperformed the market over the past decade. That's how they got big in the first place!
Returns and attention have led investors to inflate valuations commensurate with underlying performance.
Valuations for the rest of the S&P 500 and small- and mid-cap stocks look reasonable by comparison.
To be fair, Mag 7 stock's valuation has been rising for a while now, and the company continues to deliver results. That's why these stocks continue to rise in value.
Here's the trillion-dollar question: As expectations continue to rise, what happens if they temporarily fail to exceed expectations? That's the big risk for these stocks.
Another question is, how could this happen?
Cembalest also shared a graph that puts the current AI capital spending glut into historical perspective.
Nvidia data centers are expected to bring about the same amount of capital investment in terms of market share as IBM during the Nifty-Fifty era of the late 1960s or the networking stocks of the dot-com bubble.
I'm running out of adjectives to describe what's going on here. Is it surprising? Shocking? Is it surprising?
And who's spending all that money on Nvidia data centers? As you might expect, other Mag 7 stocks are as well. Ultimately, the market will demand a return on investment from all this capital investment.
Perhaps advances in AI will begin soon. Once a killer AI app is released, the impressive takeover from AI spending by big tech companies could lead to business and consumer adoption.
We cannot completely exclude that possibility. If that happens, Mag 7's monopoly will become even more powerful.
The downside risk may be that expectations become too high and these companies fail to overcome the increasingly high hurdles. All your data center capital investments may take longer to bear fruit than you expect.
What's interesting about Cembalest's comparison of two historical capital expenditure excesses is that while both failed in the short term, they still worked well in the long term.
The defining stock of the late 1960s and early 1970s was the Nifty Fifty blue chip stock. Companies like Coca-Cola, McDonald's, Xerox, Polaroid, and J.C. Penney were bid to nosebleed valuation levels before crashing and burning. Some of these stocks traded at P/E ratios as high as 50 to 70 times, and then fell 60 to 90 percent from their highs.
But over the long term, many of the same stocks have fared well for investors willing to endure the pain.
A similar dynamic occurred during the dot-com boom and bust. Everything people expected from the 1990s Internet craze has come true, and then some. We now have video on demand, online delivery of food, clothing, and household goods at the push of a button, wireless internet, video calling, global social networks, supercomputers that fit in our pockets, and more.
To get there, we had to survive the bursting of the dot-com bubble. The Nasdaq crashed more than 80% and took 15 years to break even because investors set expectations so high in the late 1990s.
Everything didn't happen fast enough.
It seems logical to see a similar dynamic unfolding in AI overinvestment. Profits can be made, but not before investors take things too far and break something. Because we always get too excited about technological innovation.
So what's an investor to do?
Strong arguments can be made in either direction.
Get out of mega cap tech stocks now! The valuation is too high, so there is a possibility that the price will go down someday.
or
It's the only game in town, so go all out on Mega Cap Tech. They will become even bigger and stronger in a few years when artificial intelligence takes over the world.
Oh, I can't predict the future.
To be honest, neither of these scenarios is a complete shock. I don't know which path I will take. There are too many unknowns to answer that question.
Human nature is both predictable and unpredictable.
My solution to this conundrum is:
I own an index fund and have diversified investments.
Index funds end up owning the winners without picking the winners in advance. And diversification often yields winners from unexpected places.
It's not a black and white answer. I'm not going to give this my all or give it my all.
I prefer investing in gray areas.
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