The Yellow Warning Light Is Flashing

The S&P 500 three ways... Focusing on value... The reversal hasn't started yet... The Magnificent Seven are like shipping companies... Nobody thinks this way right now... A warning light is flashing...

You probably need to buy the S&P 500 Index differently...

That was my (Dan Ferris') message on Monday.

You see, investors today are concentrated in the S&P 500 because it's weighted by market capitalization. So the largest-cap stocks take up the largest share of the index and the smallest-cap stocks get the smallest share.

Right now, the top 10 companies in the S&P 500 account for around 40% of the index. That means, if you're buying the S&P 500 Index, you're focusing most of your money on the top 10 stocks – which include the "Magnificent Seven," the mega-cap tech names that have dominated the index for the past several years.

But there's another way to buy equal positions of those same 500 stocks, and it stands to outperform the cap-weighted index when this mega-bubble pops. There's even an exchange-traded fund that does just that... the Invesco S&P 500 Equal Weight Fund (RSP).

As I showed earlier this week, the equally weighted index recovered much faster than the cap-weighted index in the aftermath of the Nifty Fifty crash in the early 1970s.

But today, I'll explain why the S&P 500 Value Index might be an even better idea...

Focusing on value...

Value-focused asset manager Lyrical Asset Management recently published its 2024 U.S. Value Review Letter.

Like me, Lyrical doesn't own the Mag Seven stocks because it's a disciplined value shop. And as it turns out, right now might be a very good time to focus on value.

When comparing the relative performance of the S&P 500 and its equal-weight counterpart since 1990, Lyrical found that previous episodes of outperformance were sometimes followed by extreme underperformance. Simply put, the S&P 500 and its equal-weight version tend to swap outperformance with one another, as you can see in Lyrical's chart:

The S&P 500 outperforms for a while... then the equal-weight index outperforms for a while... and so it goes, back and forth over the last 34 years.

The S&P 500 outperformed the equal-weight index by around 12% in 2023 and again in 2024. What happens next could wind up similar to what happened during the dot-com era. As Lyrical says in its letter:

The only other two calendar year span in this record that resembles the last two years is the Tech Bubble years of 1998 and 1999, where the S&P 500 outperformed by 16.4 and 9 percentage points, compounding to 30 percentage points.

Following those two Tech Bubble years, the S&P 500 went on to cumulatively underperform the S&P 500 Equal Weight by 76.2 percentage points over the next six years from 2000 to 2005.

Now, we don't believe that the future will be a carbon copy of the past... But the S&P 500 won't outperform the equal-weight index forever. And given the current market's resemblance to the dot-com era, we could see the trend reverse starting this year.

However, as we pointed out earlier this week, the S&P 500's performance has been dominated by a few large stocks. That makes it insanely difficult to be a bottom-up stock picker.

That's where value comes in...

You would have done better by buying the S&P 500 Value Index than the equal-weight index over the past two years. While the equal-weight index returned 28.7% during the last two years, the value index returned 37.2%.

Both were dwarfed by the 57.9% return the cap-weighted index saw... But perhaps the value index points the way forward for investors over the next few years.

It's worth noting that during the dot-com crash – from the S&P 500's March 24, 2000 peak to its October 9, 2002 bottom – the equal-weight index outperformed the value index.

So maybe there's no slam-dunk trade. But importantly, both the equal-weight index and value index outperformed the cap-weighted index during the dot-com bust. And the value index has done better than the equal-weight index over the past two years. So I expect both indexes to beat the S&P 500 starting very soon.

Clearly, the reversal hasn't started yet...

Over the past 12 months, the equal-weight index is up about 14%, the value index is up about 13%, and the S&P 500 is up about 22%. And the cap-weighted index has continued to outperform since the U.S. presidential election, when "animal spirits" returned to the market. The S&P 500 is up about 5.7% since Election Day, while the value and equal-weight indexes are up around 1.3% and 0.4%, respectively.

Still, the point isn't to time the market. Nobody's timing is ever perfect, except by luck. And the S&P 500's extreme concentration has created a riskier proposition for index investors (like many retirees) than they likely understand.

As we said earlier, the Mag 7 stocks make up a large portion of the S&P 500 right now.

Lyrical points out that without the Mag 7, the S&P 500 would have returned 33.8% the last two years (instead of 57.9%). That still beats the equal-weight index and is just slightly lower than the value index, but it underscores that the cap-weighted index's extreme outperformance has depended almost entirely on seven stocks.

With the Mag 7 trading at an average of more than 40 times earnings, it seems that investors don't believe this group of tech stocks will do anything but continue to soar. They're guilty of extreme optimism, much of it based on a widely hyped, highly uncertain category of investments...

Dan Rasmussen of Boston-based Verdad Advisers suggests that the estimated $1 trillion-plus that companies are investing into artificial intelligence ("AI") in the coming years – most of it by the Mag 7 – will struggle to earn a return at all, let alone one that justifies current valuations. As he says:

The skeptic's case starts with the possibility that the Mag 7 is suffering from a classic case of "competition neglect," where "subjects in competitive settings overestimate their own skill and speed in responding to common observable shocks and underestimate the skill and responsiveness of their competitors," as Robin Greenwood and Samuel Hanson put it in their paper, "Waves in Ship Prices and Investment."

The paper Rasmussen mentions shows that higher shipping rates attract more investment in ships, which drives up the cost of building them and causes a supply glut once they're all built. That depresses ship rates below where they were when everybody started building ships. The paper suggests that investing at the top of this cycle generates returns as low as negative 36% per annum and that investing at the bottom of the cycle – when nobody else wants to do so – generates returns as high as 24% per annum.

AI isn't ships, but the analogy is probably better than you think. As Rasmussen says:

Rather than ships, today's AI capex "is a euphemism for building physical data centers with land, power, steel and industrial capacity," as Sequoia Capital's David Cahn puts it.

In other words, the enormous investments companies are pouring into AI may generate returns less like capital-efficient software companies and more like capital-intensive, highly cyclical, lower-margin shipping companies. And folks investing in AI right now may be a lot closer to the top of the cycle – where returns are mediocre to negative – than the bottom.

As Rasmussen warns:

Maybe the Mag 7 will be outmaneuvered by their true heirs, another group of as-yet-unknown young innovators who are toiling away all over the world in garages far less expensive than the $1,700/square foot you have to pay to live in the cushy confines of Silicon Valley.

It's a timely message, given the recent revelation that Chinese AI firm DeepSeek trained its models for less than $6 million while the Mag 7 continue to spend billions. It should alarm investors that the DeepSeek news took 3% off the Nasdaq Composite Index and more than 3% off the Mag 7, including a 17% drop in AI darling Nvidia (NVDA).

So there's no reason to believe that the semiconductor industry isn't still highly cyclical and capital intensive. It explains why Nvidia was by far the worst-performing Mag 7 stock on the day the DeepSeek news broke.

But maybe it isn't just Nvidia... and the entire Mag 7 acts more like the semiconductor industry than the software industry. And what if investors soon realize that AI won't generate enough returns to justify the Mag 7's massive investments in it?

Given how expensive Mag 7 valuations are right now, very few investors are thinking this way. They're throwing caution to the wind and pushing the most popular stocks of the last decade ever higher.

In fact, one indicator shows investors are as bullish as ever...

The chart below shows the Goldman Sachs Bull-Bear Indicator since 1995...

As you can see, investors are every bit as bullish today as they were in 2000, 2007, and 2018... And they're even more bullish than they were at the top in late 2021 and early 2022.

The Goldman Sachs Bull-Bear Indicator is not a timing indicator. But it's another sign that U.S. stocks are far riskier than the average investor likely understands today.

A caveat from my favorite valuation measure of the U.S. stock market...

Economists Robert Shiller and John Campbell created the cyclically adjusted price-to-earnings ("CAPE") ratio in 1988 and brought it to the Federal Reserve's attention in 1996. They used it to show that U.S. equity markets were too expensive and priced for poor returns.

They were right. When the dot-com bubble finally burst in March 2000, it eventually took the S&P 500 back down to around its 1996 highs, wiping out all the gains of the era.

CAPE was hailed as a success after that but has garnered criticism over the past several years for no longer being relevant. One problem is that the S&P 500 regularly deletes and adds companies.

Since CAPE uses the current market value of the S&P 500 divided by the index's 10-year cyclically adjusted earnings, the 10-year earnings part of the calculation has stocks that are no longer in the current market value of the index.

The folks at Research Affiliates propose to fix this by simply using only the 10-year average earnings of the current constituents, which they call "CC CAPE."

CC CAPE shows that stocks are more expensive than CAPE when markets are soaring. For example, CAPE was 44 at the dot-com peak. CC CAPE was 68. When CAPE was 37.4 on November 30, 2024 (which, as I've been saying, is one of its highest levels), CC CAPE was 43.4.

But CC CAPE's creators say the best way to measure it as a sentiment indicator is by its spread over CAPE. A wider spread means higher risk.

As you can see in the chart from Research Affiliates below, the CC CAPE/CAPE spread has spent most of its time below 5 since around the mid-1970s, except for a period from 1995 to 2008. It was more than 25 at the dot-com peak and is around 5 today (based on the latest data available from November 2024).

So CAPE is elevated however you measure it... As Research Affiliates says, the current "elevated enthusiasm may not yet be a red light" for U.S. stocks, but "we could be facing a flashing yellow."

In short, the long-term valuation of the market might not be in red-light territory, but investors have only been this enthusiastic in the past at or near bubble peaks.

I believe we're close enough to a massive bubble peak to warrant a good deal of caution.

Reallocating a 401(k) from the S&P 500 to a value or equal-weight index is probably a prudent move. And of course, it doesn't have to be an all-or-nothing move. You can simply allocate more into value and equal-weight funds going forward.

Of course, no matter which version of the S&P 500 you buy – cap weighted, equal weight, or value – you'll still experience a drawdown in a bear market. But the value and equal-weight indexes will likely outperform the S&P 500 when that happens. That's true whether the ultimate top comes next week or next year.

New 52-week highs (as of 2/13/25): Automatic Data Processing (ADP), Agnico Eagle Mines (AEM), Alamos Gold (AGI), Alpha Architect 1-3 Month Box Fund (BOXX), Blackstone Secured Lending Fund (BXSL), CME Group (CME), Coca-Cola Consolidated (COKE), Costco Wholesale (COST), Cisco Systems (CSCO), Simplify Managed Futures Strategy Fund (CTA), Commvault Systems (CVLT), CyberArk Software (CYBR), Equinox Gold (EQX), Expedia (EXPE), SPDR Euro STOXX 50 Fund (FEZ), Franco-Nevada (FNV), Fortinet (FTNT), Gilead Sciences (GILD), SPDR Gold Shares (GLD), Intercontinental Exchange (ICE), Grand Canyon Education (LOPE), Meta Platforms (META), Neuberger Berman Next Generation Connectivity Fund (NBXG), Annaly Capital Management (NLY), Sprott Physical Gold Trust (PHYS), Rithm Capital (RITM), Republic Services (RSG), Sandstorm Gold (SAND), Sprouts Farmers Market (SFM), S&P Global (SPGI), Spotify Technology (SPOT), Torex Gold Resources (TORXF), Tyler Technologies (TYL), UGI (UGI), ProShares Ultra Gold (UGL), United States Commodity Index Fund (USCI), Visa (V), Verisk Analytics (VRSK), VeriSign (VRSN), and Wheaton Precious Metals (WPM).

One quick housekeeping note: Our offices and the U.S. markets will be closed on Monday for Presidents Day... Following this weekend's Masters Series, we'll pick up with our regular Digest coverage on Tuesday. Have a great holiday weekend.

In today's mailbag, a prediction on the path of inflation, which we discussed in yesterday's edition... Do you have a comment or question? As always, e-mail us at [email protected].

"Anyone who knows the markets knows that the market always prices in today what it thinks will be happening six months down the road. Still true today... Six months from now, prices will be down, interest rates will be lower..." – Stansberry Alliance member Nick P.

Good investing,

Dan Ferris
Medford, Oregon
February 14, 2025

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Please note: Securities appearing in the Top 10 are not necessarily recommended buys at current prices. The list reflects the best-performing positions currently in the model portfolio of any Stansberry Research publication. The buy date reflects when the editor recommended the investment in the listed publication, and the return shows its performance since that date. To learn if a security is still a recommended buy today, you must be a subscriber to that publication and refer to the most recent portfolio.

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