Leading Growth Stocks Behaving Nicely Defensive as Well
Schwab’s chief investment strategist is telling us that we need to be wary of big growth stocks because they are riskier in bear markets. We’re seeing the opposite though.
We often speak of all the misunderstanding that there is out there about risk with holding stocks, which mostly occurs from our looking to view risk in isolation and not dynamically, looking at how these risks play out over time when we account for both risk and return. Usually they don’t bother to even look at all.
People speak of the additional risk that stocks that grow a lot more than the market does, and this is even taken as a given, without even checking these things. Perhaps we remember a certain stock going down more than the market has at one point, and then become willing to pay a huge price to protect ourselves against this perceived excessive risk.
There’s too much on the line for us to be flying on the seat of our pants with this or any other investment decision that we make, when we don’t even take a good peek at whether our assumptions about these stocks are true. We showed you in a recent article that the tech SPDR, the companies in the S&P 500 that are in the technology sector, is actually less risky than the broad index, as an example of how we can’t just make a guess at these things without looking and what can be revealed when we do dare to question our beliefs enough to subject them to a little checking.
When we compare the returns that we get from higher growth stocks, we see that they both return a lot more profit to us while actually doing so in a less risky manner than the potpourri strategy of buying the whole index. If this index returns a lot less, and we pick it over something significantly better, the difference is our opportunity cost, what we have given up to do what we did instead.
If we instead compared this index with something truly riskier, like if we were investing with enough leverage that we are prone to a margin call, like the leveraged inverse bond trade we spoke about yesterday then it might make sense to pull back. It’s not that you couldn’t put your whole portfolio into something like this safely enough, but not without risk controls and management, because you can’t just let something like this run against you without either exiting long before that, or as a last resort, covering your margin call by selling some of your other assets.
There is therefore a threshold of risk that we need to account for, but in order to have much of an idea of what amount this is, we need to actually look at the risk involved and then and only then be in a position to decide. We can’t just think that the better stocks in the market are by nature riskier, and then settle for a whole lot less because we are don’t even bother to look, or just believe all the rhetoric out there which tells us that this is just too risky of an idea.
The reason why we told you that investors should only put a portion of their assets into this bond ETF is because the risk with going all in with this is meaningful, and even though it’s unlikely to bonds to see their yields drop all that much further, we need a plan if it does, and those who are exposed to this risk need to be able to stay out of the quicksand. The last thing we want is people following our recommendations and end up being badly burned.
There’s a big difference between a bold move like this and just going with a small basket of good performing stocks, like the FAANG+M that is so widely followed. This involves Facebook, Apple, Amazon, Netflix, and Google, the FAANG part, along with Microsoft, the M.
The 5 not including Netflix are the top 5 stocks on the S&P 500 that we talked about representing 20% of the index, and this has since gone up to 21% now. Netflix has become added to this list, as while its market cap is not in the same league, this is very well-loved stock that has outperformed everything over the last 10 years and has certainly earned its place among the other FAANG+M stocks, aside from needing the letter N to spell FAANG.
We also told you that these stocks being so top heavy does bother a lot of folks, and Schwab’s chief investment officer Liz Ann Sonders stepped up to the mic on Friday to voice her concerns about this. We did an article earlier this year about Schwab and their pushing diversification and balancing to their clients, and while we don’t want to single them out as just about everyone believes these things, their CIO is clearly on board with this based upon her remarks, along with just about everyone else in the business.
We explained why this is actually a good thing if you actually do want to make more money from your stocks, and these stocks are in themselves responsible for the index itself doing as well as it has, because they have done much better and even with their impressive returns diluted by all these other stocks, the index has done decently well over the last decade.
Rather than be worried about such a thing, we want to take the other side of the idea to the extreme for you, where we’re going to see what happens if we put all of our money into FAANG+M and see how both the risk and the return side stacks up. Our stocks will cream the index on returns, as this is a given, and it’s the idea that this would be a lot riskier of an investment strategy or even riskier that is what we’ll be focusing on the most, to help dispel the illusion that is so widely held that would give people so much pause that they would think the idea as simply crazy.
Let’s Take On the Market with This Popular Basket of Top Stocks
We have to build our own index here, as you can’t invest in this, even though there is a FAANG+ ETF out there that looks like it may be the same thing. It isn’t though, and this ETF has some extra stocks thrown in there, some which just aren’t good stocks like Baidu and Alibaba, or great stocks that actually are too volatile and require close monitoring, like Tesla. We’ll stick with the standard six for this ride, and this does provide us with a good amount of diversification already, with a search engine, a software maker, a social media platform, a hardware company, an online retail operation, and a streaming service.
This is a true all-star team, with all very much immersed in success in the present and also very well positioned to continue to grow in the future, and a stock needs both to make our team. The fact that all these stocks are very well loved by the market is also required for them to measure up to our high standards.
Because we understand the dynamic relationship between risk and returns, where the higher the potential returns, the more risk that can be tolerated, we know that stocks like this not only behave in a less risky way overall, they perform so much better than the market to reduce risk very substantially over the amount that the market is subject to.
Hearing an analyst complain about stocks that have been run up is nothing new, or is their having concerns about an index like the S&P being so top heavy. What stood out so much for us about Sonders’ remarks is that she told us that her concerns were about all the extra risk that these top stocks would subject us to in a bear market, even though we just had one and one that represents her fears coming home to roost and the event right in front of our faces now.
In spite of a very impressive recovery, the S&P 500 is still down for the year, and if the FAANG+M really is risky, we would see a bigger decline. We want to start by looking at 2020 and then we can move on to show how this plays out over longer time periods.
Just the fact that our stocks may have underperformed the market in a downturn would not in itself turn us off toward them, because we know that in the good times, they will outperform the index to such an extent to make a measly extra 5% or whatever the worry is here meaningless. If you are up 100% and give back 5% or 10% or even 20%, you are still way ahead, and being well ahead is not anything that anyone should describe as risk.
The benchmark is the 13% that the S&P 500 is down in 2020 as of Friday’s close, and we’ll compare the average of our stocks to see how much further they may have dropped, or not. Facebook, Google, and Apple are off by 2%, Microsoft is up by 10%, Amazon is ahead by 22%, and Netflix is up by 27%. Our equally weighted index is up 9% this year, clearly better than the 13% the big index is down, with a difference of 22% in just a third of a year.
Top Stocks Not Only Flatten Indexes Over Time, they Do It with Less Risk Overall
Is this the bear market that we’re supposed to be afraid of with these stocks? We don’t just want to cite just one bear market, and although it’s been a while since we had one, we can also look at the 2008 bear and see how we measured up against a bear that ferocious.
We’ll take the peak to valley results of that bear market to see how our index measures up with the big one in this regard. The S&P 500 had a maximum drawdown of 58%. Facebook wasn’t around back then, but the other 5 were. Google took the biggest hit at 63%, with Microsoft and Amazon both dropping by 59%, Apple giving back 54%, and Netflix dropping by 36%.
Our index is therefore only down 54%, 4% less than the big index fell. This is the worst-case scenario for our index if you are worrying about how far it might fall in a crash, and these numbers clearly demonstrate that this was a crash indeed, and a bigger one for sure than the one we saw so far this year.
This really doesn’t matter unless you had the extraordinary unlikely bad luck of buying right at the peak of a crash and then having to sell everything right at the bottom. This never happens to anyone, and we need to account for not where it went but where it is when it matters to us, later on and usually a lot later on. If you’re going to keep your stocks through something like this, you surely should continue to do so after the damage has been done.
Our needing to care about total drawdown risk like this is a myth, but as we can see, the idea that there is a lot more risk or even more risk is a myth as well. This illusion likely occurs because people are presuming that our stocks are “overvalued,” and there is more that they are supposed to give back in a downturn, but in reality, they are still preferred overall to lesser stocks even in a big move down like this, and even the worst performer, Amazon, only lost an extra 4%.
In order to show how much room that we have created since then, we’ll take these 2007 peak levels and measure them against where we are now, where the love of our stocks has been given lots of opportunity to weigh in, over 12 years in fact. We have to leave Facebook out of this again because this started before the stock was traded.
We’ll use September 2007 levels until now, with the S&P is up 95% over this time. Google grew by 555%, Microsoft by 621%, Apple by 1,536%, Amazon by 2,705%, and Netflix by 16,100%. Our index therefore grew by 4,303%, and if it lost 90% of its value from here while the market didn’t go down at all, it would still be worth over 4 times as much as the big index.
Let’s do one more so we can get all 6 of the stocks in the little index we put together for this article and see another head to head battle with the “market.” We want to pick a time where all of these stocks were huge and very well known as great, where their dominance had played out so much that even your kids know these are all good stocks, where no skill should have ever been required to know that they are very well loved and therefore the sort we should want if we understand the nature of love and stocks.
Not a lot of people get that stocks go up because people like them, and the ones they like the most therefore go up the most. This is not a theory, as it is not only what happens but the only thing that could happen, demand overwhelming supply over a long period by way of high enough demand.
The S&P 500 has only moved up by 6% over the last 2 years, and it’s actually 5.6% but we’re using rounding here as these comparisons are so distant that whole percentages are plenty. Facebook is up 14%, Google is up 26%, Netflix is up 29%, Amazon is up 44%, Apple is up 56%, and Microsoft is up 83%.
We actually should be dropping Facebook based upon this, as this might be 8% more than the market gained but this shows us that it does not have the spring in its step that we need it to have anymore. Keeping it in there still has our index going up by 42, seven times the return of the S&P 500. The trimmed down MAANG takes us up to a 2-year return of 48%, eight times the return of the S&P 500 now.
We can take a lot more bashing if we need to and still be way ahead, not that this has even happened with this and the last bear, and that’s the real point of looking at how risk actually plays out when return is thrown in there as well. The only thing to be afraid of with these stocks is being afraid of making a lot more money much more safely.
It’s fine to make assumptions, and every proven idea starts with making them, but we can’t skip the second step, examining them to see if they hold true. We can’t just assume that it’s better or a lot better to spread things around as much as we do, just because that’s what they say to do, with even the ones saying it not recognizing that it is just dogma.
With investing, dogma leads to a lot of dogs, and not the ones like ours who are prancing around and receiving their ribbons, we’re talking a pack of dogs that range from the nice ones to ones that need to be caged to prevent their attacking you. This is a real dog show though, where the quality of your dogs really matter, and we should not be so willing to take on so many mutts, and especially should not make this our top priority.
We always choose our stocks, whether we do so actively or by choosing an index. When it comes to stocks, quality matters, and quality is the most important thing by far. We at least owe it to ourselves to at least have a look.
Editor, MarketReview.com
Monica uses a balanced approach to investment analysis, ensuring that we looking at the right things and not confined to a single and limiting theory which can lead us astray.
Contact Monica: monica@marketreview.com
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