2023-12-23 07:15:00 ET
Summary
- Warren Buffett's stock sales and cash pile, warnings from billionaires and economists, and market valuation models suggest a major market downturn could be ahead.
- We believe that Schwab U.S. Large-Cap Growth ETF™ could see severe underperformance in such a scenario.
- We take a closer look at market dynamics and the SCHG ETF's underlying structure to explain why.
Warren Buffett's recent significant stock sales and massive cash pile, warnings from a plethora of billionaire business tycoons, leading economists, indications from prominent investors such as Elon Musk and "The Big Short" Michael Burry, a number of prominent market valuation and macroeconomic models - all these suggest the market is overvalued and the economy is headed for recession. This seems to indicate that the market has a major downturn in store for it in 2024.
In this article, we will review the current outlook for the U.S. economy and stock market, and then share why we believe that the Schwab U.S. Large-Cap Growth ETF (SCHG) is likely to materially underperform moving forward.
Is The Stock Market Headed Lower In 2024?
The U.S. economy and stock market appear to be on shaky ground as we head into 2024. Current economic indicators and market trends suggest a mixed outlook, with potential headwinds that could lead to a downturn, especially for mega-cap tech stocks.
First of all, while the U.S. economy has shown resilience in 2023, which has surprised many pundits,?? it appears it is finally weakening. The Organization for Economic Cooperation and Development ((OECD)) forecasts a deceleration of growth to just 1.5% in 2024, a significant reduction from the expected 2.4% rate in 2023??. Moreover, many are even predicting a recession next year.
Turning to the stock market, specifically the tech sector, there are several signs of potential headwinds in 2024. Long-time wealth advisor Ted Oakley has likened the Big Tech boom to the dot-com bubble, forecasting a stock market slump and a recession within the next six months. In particular, he pointed to the consolidation of market gains in a handful of tech giants - commonly referred to as the "Magnificent Seven" - as mirroring the late 1990s scenario where the hype around a new technological era (back then it was the Internet, today it is artificial intelligence, or AI) led to a market bubble and subsequent crash.
Additionally, Warren Buffett's Berkshire Hathaway ( BRK.A , BRK.B ) has reportedly been a significant net seller of stocks ($28.7 billion worth, in fact) recently (including positions in vaunted Dividend Kings like Procter & Gamble ( PG ) and Johnson & Johnson ( JNJ )), amassing a record cash pile in the process. Given that Buffett prides himself on almost always being a net buyer of stocks, this could very possibly be signaling a cautious or even pessimistic market outlook.
Moreover, leading business figures, investors, and economists such as Michael Burry of 'Big Short' fame, Tesla ( TSLA ), X, and SpaceX (SPACE) tycoon Elon Musk , Citadel's Ken Griffin , famed bond investors Bill Gross and Jeff Gundlach , JPMorgan Chase's ( JPM ) senior executives Bob Michele and Mike Wilson , and respected economists David Rosenberg and Stephanie Pomboy have all raised concerns about the U.S. economy and near-term stock market outlook in recent months. Even Peter Lynch - while bullish on small-cap stocks ( IWM ) - made it clear that mega-cap stocks are driving the stock market bubble, creating a significant valuation mismatch between the largest stocks and small-cap ones.
Last, but not least, several leading indicators are pointing to a significant overvaluation of the S&P 500 (SP500) as well as a high probability of a recession hitting the economy in the near future.
The Buffett Indicator Model currently has a value of 175%, which is 1.4 standard deviations above the historical trend line, indicating the market is Overvalued. The S&P 500 Mean Reversion Model currently indicates that the index is 1.3 standard deviations above its historical trend line, suggesting that it is currently overvalued. Finally, the Price/Earnings Ratio Model is 52.9% above the modern-era market average of 20.2, or 1.3 standard deviations above average, thereby indicating that the S&P 500 is significantly overvalued.
Recession indicators such as the Yield Curve Inversion Model and the State Coincidence Indicator Model both also seem to indicate that there is a high probability of an upcoming recession.
Combining the concerns of numerous highly respected experts with market valuation and recession indicator models leads us to the conclusion that investors would be prudent to at least take some precautions with their portfolios heading into 2024.
Why SCHG Is A Sell Right Now
With this in mind, we think that holding a large position in SCHG at the moment is not prudent because it has outsized exposure to the magnificent seven mega-cap technology stocks, which are richly valued and appear poised for a meaningful pullback - or at the very least underperformance - next year. As the list below demonstrates, its top seven holdings all belong to the Magnificent Seven and make up a whopping 50% of its portfolio. As a result, it is little more than a proxy for investing in the Magnificent Seven on a market cap-weighted basis.
- Apple Inc ( AAPL ) - 12.78%
- Microsoft Corp ( MSFT ) - 12.32%
- Amazon.com Inc ( AMZN ) - 6.20%
- NVIDIA Corp ( NVDA ) - 5.43%
- Alphabet Inc Class A ( GOOGL ) - 3.58%
- Meta Platforms Inc Class A (META) - 3.46%
- Tesla Inc ( TSLA ) - 3.16%
- Alphabet Inc Class C ( GOOG ) - 3.05%
- Broadcom Inc ( AVGO ) - 2.23%
- UnitedHealth Group Inc ( UNH ) - 2.16%
Moreover, even beyond its outsized exposure to technology, SCHG has meaningful exposure to the Consumer Cyclical sector (12.87%), which is also quite sensitive to recessions and will likely underperform in a macroeconomic scenario in which the economy is slowing or even contracting.
Yes, SCHG's expense ratio of just 0.04% makes it a very low-cost ETF and it is not a bad way to invest in mega-cap stocks. However, given the aforementioned macroeconomic and market valuation data, we think that now is not a good time to be holding this ETF.
To further illustrate just how overvalued SCHG is, its two largest positions - AAPL and MSFT, which make up over a quarter of its portfolio - are priced at massive premiums to their historical valuation metrics.
AAPL currently trades at about 30 times its expected forward free cash flow, nearly double its historical average of 18 times free cash flow multiple. Moreover, its EV/EBITDA premium is more than double its historical average, standing at 22.72 times, compared to its historical average of just 11.09x.
MSFT, meanwhile, currently trades at 42 times its expected forward free cash flow, more than double its historical average of 20.44 times free cash flow multiple. Moreover, its EV/EBITDA premium is nearly just as significant, standing at 21.61 times, compared to its historical average of 12.42 times.
Are AAPL and MSFT likely to keep growing their earnings per share moving forward? Absolutely. However, is their earnings growth accelerating at a rapid pace? It is highly unlikely to do so moving forward, and analysts - despite the current market euphoria surrounding the stock - seem to agree. AAPL is expected to grow its normalized earnings per share at a 7% rate in 2024 and an 8.5% rate in 2025, which is good but definitely nothing spectacular given its current valuation multiples and its paltry 0.5% dividend yield.
MSFT, meanwhile, is expected to grow its normalized earnings per share at a much more robust 14% next year and 15% in 2025. Still, while this is a big improvement, is it really worth paying the lofty 33 times forward earnings multiple and 42 times free cash flow multiple that the market is asking for shares today? I think not, especially given the mere 0.8% dividend yield and the fact that there are plenty of other stocks in the market today that are much cheaper and offer a similar yield plus growth profile.
As a result, should a recession hit and consumer demand declines for iPhones, laptops, and software products, AAPL and MSFT will likely underperform earnings estimates and market sentiment will shift, causing a rapid rerating lower for these stocks, thereby having an outsized negative impact on SCHD.
Investor Takeaway
Current market dynamics and some economic forecasts from several highly respected business leaders, investors, and economists signal potential underperformance may be ahead for mega-cap stocks. Given SCHG's significant exposure to the 'Magnificent Seven' mega-cap tech stocks, which constitute half of its portfolio and look rather richly valued at the moment, we think that this ETF could face significant underperformance in the coming months and years. As a result, we rate it a Sell and think investors would be better served by investing in more attractively priced and more defensive segments of the market, such as utilities ( XLU ), REITs ( VNQ ), MLPs ( AMLP ), and/or dividend growth stocks ( VIG )( SCHD ).
For further details see:
Buffett's Stock Sales, Musk, Lynch, And More Signal Downturn: Avoid SCHG