Warren Buffett: 'It takes just a few winners to work wonders' 🏆
Plus a charted review of the macro crosscurrents 🔀
📈 Stocks rallied to new all-time highs, with the S&P 500 setting a record intraday high of 5,505.53 on Thursday and a record closing high of 5,487.03 on Tuesday. For the week, the S&P gained 0.6% to end at 5,464.62. The index is now up 14.6% year to date and up 52.8% from its October 12, 2022 closing low of 3,577.03.
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One of the most powerful aspects of the stock market is laid out in TKer Stock Market Truth No. 4: “Stocks offer asymmetric upside.“
A stock can only go down by 100%, but there’s no limit to how many times its price can multiply going up.
This phenomenon has been on full display with the rise of AI-hardware giant Nvidia. And this recent headline from Bloomberg says it all: “Nvidia’s 591,078% Rally to Most Valuable Stock Came in Waves.“
However, today’s discussion isn’t just about how you can make a fortune on a single stock.
Rather, it’s about how the performance of a few extraordinary stocks helps us better understand why the stock market broadly delivers the returns it does.
It also may help us understand what it’s like to be investing like Warren Buffett.
A few stocks have been responsible for the bulk of the market’s returns for decades ⚖️
History tells us that the stock market has usually gone up. But that doesn’t mean all stocks go up. Far from it.
In 2017, Arizona State University professor Hendrik Bessembinder made waves with his research paper that observed most stocks had been pretty crummy investments that underperform Treasury bills. Read the news coverage here, here, and here.
Bessembinder published another paper in 2020 with some updated stats that were similarly dismal. From the paper (emphasis added):
…The study includes all of the 26,168 firms with publicly-traded U.S. common stock since 1926. Despite the fact that investments in the majority (57.8%) of stocks led to reduced rather than increased shareholder wealth, U.S. stock market investments on net increased shareholder wealth by $47.4 trillion between 1926 and 2019. Technology firms accounted for the largest share, $9.0 trillion, of the total, but Telecommunications, Energy, and Healthcare/ Pharmaceutical stocks created wealth disproportionate to the numbers of firms in the industries. The degree to which stock market wealth creation is concentrated in a few top-performing firms has increased over time, and was particularly strong during the most recent three years, when five firms accounted for 22% of net wealth creation…
When you consider Bessembinder’s stats alongside the fact that the market as a whole has historically generated an average of 8%-10% per year, you begin to understand that there’s a tremendous skew in the distribution of returns among individual stocks.
In other words: The market’s average returns are the result of a small handful of stocks generating eye-popping returns that offset the majority of stocks producing market-lagging returns.
In a report published in April 2023, S&P Dow Jones Indices (SPDJI) came to a similar conclusion after looking into the historical performance of the S&P 500. Specifically, they found that only 24% of the stocks in the S&P 500 outperformed the average stock’s return from 2002 to 2022.
“One of the most consistent characteristics of global equity markets is that returns are positively skewed — when graphed, they have a long right tail,” wrote SPDJI’s Craig Lazzara (emphasis added). “This is intrinsically logical, since a stock can only lose 100% but has unlimited upside.”
Over Lazzara’s measurement period, the average return on an S&P 500 stock was 390%, while the median stock rose by just 93%.
“In such a market, a manager’s success is dependent on his ownership of a relatively small number of strong performers,” he wrote (emphasis added).
Warren Buffett would agree with that sentiment.
‘It takes just a few winners to work wonders’ 🏆
Buffett, CEO of Berkshire Hathaway, is often praised as history’s greatest investor. His legendary knack for picking stocks for Berkshire’ equity portfolio helps explain why the company’s shares have massively outperformed the S&P 500 over the years.
However, returns have not been evenly distributed across Berkshire’s stock holdings.
“Over the years, I have made many mistakes,” Buffett explained in his annual letter published in 2023 (emphasis added). “Our satisfactory results have been the product of about a dozen truly good decisions — that would be about one every five years.“
At the time, he walked through examples including Coca-Cola and American Express, which multiplied in value many times over while returning massive cash dividends. Read more about it here.
“The lesson for investors: The weeds wither away in significance as the flowers bloom,” Buffett said. “Over time, it takes just a few winners to work wonders.”
In his annual letter published this past February, he discussed those positions again, saying (emphasis added): “Patience pays, and one wonderful business can offset the many mediocre decisions that are inevitable.”
Is what’s happening today so different from history?
The chart below from Bespoke Investment Group shows how the “Magnificent 7” tech names have been responsible for nearly half of the S&P 500’s returns since the beginning of the bull market in October 2022.
The non-Magnificent names haven’t exactly been mediocre. But it’s clear that the strength of a few stocks have mattered.
And so I’d argue Bessembinder and Buffett’s insights can be applied to Nvidia and the megacap tech stocks and their effect on broad market returns.
Sure, the concentration of the stock market winners today is unusual in many ways. But the general concept of a minority of names driving the bulk of returns is nothing new. It defines why the broad stock market has climbed for years. And it also explains why Warren Buffett has been so successful.
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Related from TKer:
Citi and Capital Economics raise their targets for the S&P 500 📈
On Monday, Citi’s Scott Chronert raised his year-end target for the S&P 500 to 5,600 from 5,100. This was his first revision from his initial target.
“The weighting effect of the mega-cap growth cohort is exerting an outsized influence on index price action,” he said.
On Friday, Capital Economics’ Thomas Mathews raised his year-end target to 6,000 from 5,500. This was his first revision as well.
“[W]e’ve been surprised by how rapidly expectations for earnings have grown,” Mathews wrote. “Growth in anticipated EPS account for a large share of the index’s gains this year. And while rapidly rising profit expectations could also be a symptom of an inflating bubble, these latest gains have followed an acceleration in actual earnings.”
Chronert and Mathews are not alone in tweaking his forecasts. Their peers at Goldman Sachs, UBS, Morgan Stanley, Deutsche Bank, BMO, CFRA, Oppenheimer, RBC, Societe Generale, BofA, and Barclays are among those who’ve also raised their targets.
Don’t be surprised to see more of these revisions as the S&P 500’s performance, so far, has exceeded many strategists’ expectations.
Reviewing the macro crosscurrents 🔀
There were a few notable data points and macroeconomic developments from last week to consider:
🛍️ Spending growth cools. Retail sales inched 0.1% higher to $703.09 billion in May.
Categories driving strength included sporting and hobby, clothes, online, and cars and parts. This was partially offset by weakness in gas stations, furniture, building materials, grocery, and restaurants and bars.
It’s more evidence that the economy has gone from very hot to pretty good.
For more, read: Economic growth: Slowdown, recession, or something else? 🇺🇸 and Stay mindful of the economic warnings signs ⚠️
💳 Card spending is holding up. From JPMorgan: “As of 07 Jun 2024, our Chase Consumer Card spending data (unadjusted) was 1.7% below the same day last year. Based on the Chase Consumer Card data through 07 Jun 2024, our estimate of the US Census May control measure of retail sales m/m is 0.67%.“
From Bank of America: “Total card spending per HH was up 1.5% y/y in the week ending Jun 15, according to BAC aggregated credit & debit card data. Retail ex auto spending per HH came in at 1.4% y/y in the week ending Jun 15. Card spending appears to be robust through mid June.”
For more on consumer finances, read: Unsettling stats about consumer health are missing the bigger picture 💵
🚗 Used car prices continue to come down. From Manheim: “Wholesale used-vehicle prices (on a mix-, mileage-, and seasonally adjusted basis) decreased 0.3% from May in the first 15 days of June. The mid-month Manheim Used Vehicle Value Index fell to 196.8, which was down 8.5% from the full month of June 2023.”
For more on prices, read: Inflation: Is the worst behind us? 🎈
💼 Unemployment claims fall. Initial claims for unemployment benefits declined to 238,000 during the week ending June 15, down from 243,000 the week prior. And while this is above the September 2022 low of 187,000, it continues to trend at levels historically associated with economic growth.
For more, read: Labor market: How cool will it get? 🥶
🛠️ Industrial activity rises. Industrial production activity in May increased 0.9% from the prior month. Manufacturing output rose 0.9%.
For more on activity stabilizing as inflation cools, read: The bullish 'goldilocks' soft landing scenario that everyone wants 😀
🏠 Mortgage rates tick lower. According to Freddie Mac, the average 30-year fixed-rate mortgage declined to 6.87% from 6.95% the week prior. From Freddie Mac: “Mortgage rates fell for the third straight week following signs of cooling inflation and market expectations of a future Fed rate cut. These lower mortgage rates coupled with the gradually improving housing supply bodes well for the housing market.”
There are 146 million housing units in the U.S., of which 86 million are owner-occupied and 39% of which are mortgage-free. Of those carrying mortgage debt, almost all have fixed-rate mortgages, and most of those mortgages have rates that were locked in before rates surged. All of this is to say: Most homeowners are not particularly sensitive to movements in home prices or mortgage rates.
For more on mortgages and home prices, read: Why home prices and rents are creating all sorts of confusion about inflation 😖
🏚 Home sales fall. Sales of previously owned homes fell by 0.7% in May to an annualized rate of 4.1 million units. From NAR chief economist Lawrence Yun: “Eventually, more inventory will help boost home sales and tame home price gains in the upcoming months. Increased housing supply spells good news for consumers who want to see more properties before making purchasing decisions.”
💸 Home prices ticked higher. Prices for previously owned homes rose to record levels. From the NAR: “The median existing-home price for all housing types in May was $419,300, the highest price ever recorded and an increase of 5.8% from one year ago ($396,500). All four U.S. regions registered price gains.“
🏠 Homebuilder sentiment falls. From the NAHB’s Carl Harris: “Persistently high mortgage rates are keeping many prospective buyers on the sidelines. … Home builders are also dealing with higher rates for construction and development loans, chronic labor shortages and a dearth of buildable lots.”
🔨 New home construction falls. Housing starts fell 5.5% in May to an annualized rate of 1.28 million units, according to the Census Bureau. Building permits fell 3.8% to an annualized rate of 1.39 million units.
For more on housing, read: The U.S. housing market has gone cold 🥶
😬 This is the stuff pros are worried about. “'Higher inflation' remains the #1 tail risk according to 32% of FMS investors, but down sharply from 41% in May,” according to BofA’s June Global Fund Manager Survey.
Meanwhile, “geopolitics” and “U.S. election” risk has been on the rise.
The truth is we’re always worried about something. That’s just the nature of investing.
For more on risks, read: Sorry, but uncertainty will always be high 😰 and Two recent instances when uncertainty seemed low and confidence was high 🌈
👍 Survey signals growth. From S&P Global’s June U.S. PMI: “The early PMI data signal the fastest economic expansion for over two years in June, hinting at an encouragingly robust end to the second quarter while at the same time inflation pressures have cooled. The PMI is running at a level broadly consistent with the economy growing at an annualized rate of just under 2.5%. The upturn is broad-based, as rising demand continues to filter through the economy. Although led by the service sector, reflecting strong domestic spending, the expansion is being supported by an ongoing recovery in manufacturing, which so far this year is enjoying its best growth spell for two years.”
Keep in mind that during times of perceived stress, soft survey data tends to be more exaggerated than actual hard data.
For more on this, read: What businesses do > what businesses say 🙊
📈 Near-term GDP growth estimates look good. The Atlanta Fed’s GDPNow model sees real GDP growth climbing at a 3.0% rate in Q2.
For more on economic growth, read: Economic growth: Slowdown, recession, or something else? 🇺🇸
💰 Stock buybacks are up — but in line with historical trends. From S&P: “Q1 2024 share repurchases were $236.8 billion, up 8.1% from Q4 2023’s $219.1 billion expenditure, and up 9.9% from Q1 2023’s $215.5 billion. For the 12-months ending March 2024, buybacks were $816.5 billion, down from $867.2 billion for the prior 12-month March 2023 period; the 12-month peak was in June 2022 with $1.005 trillion.“
While the nominal figures may seem high, buybacks as a percent of market cap is in line with the historical average.
For more on buybacks, read: The truth about the hundred of billions of dollars worth of stock buybacks 💸
Putting it all together 🤔
We continue to get evidence that we are experiencing a bullish “Goldilocks” soft landing scenario where inflation cools to manageable levels without the economy having to sink into recession.
This comes as the Federal Reserve continues to employ very tight monetary policy in its ongoing effort to get inflation under control. While it’s true that the Fed has taken a less hawkish tone in 2023 and 2024 than in 2022, and that most economists agree that the final interest rate hike of the cycle has either already happened, inflation still has to stay cool for a little while before the central bank is comfortable with price stability.
So we should expect the central bank to keep monetary policy tight, which means we should be prepared for relatively tight financial conditions (e.g., higher interest rates, tighter lending standards, and lower stock valuations) to linger. All this means monetary policy will be unfriendly to markets for the time being, and the risk the economy slips into a recession will be relatively elevated.
At the same time, we also know that stocks are discounting mechanisms — meaning that prices will have bottomed before the Fed signals a major dovish turn in monetary policy.
Also, it’s important to remember that while recession risks may be elevated, consumers are coming from a very strong financial position. Unemployed people are getting jobs, and those with jobs are getting raises.
Similarly, business finances are healthy as many corporations locked in low interest rates on their debt in recent years. Even as the threat of higher debt servicing costs looms, elevated profit margins give corporations room to absorb higher costs.
At this point, any downturn is unlikely to turn into economic calamity given that the financial health of consumers and businesses remains very strong.
And as always, long-term investors should remember that recessions and bear markets are just part of the deal when you enter the stock market with the aim of generating long-term returns. While markets have recently had some bumpy years, the long-run outlook for stocks remains positive.
For more on how the macro story is evolving, check out the the previous TKer macro crosscurrents »
TKer’s best insights about the stock market 📈
Here’s a roundup of some of TKer’s most talked-about paid and free newsletters about the stock market. All of the headlines are hyperlinked to the archived pieces.
10 truths about the stock market 📈
The stock market can be an intimidating place: It’s real money on the line, there’s an overwhelming amount of information, and people have lost fortunes in it very quickly. But it’s also a place where thoughtful investors have long accumulated a lot of wealth. The primary difference between those two outlooks is related to misconceptions about the stock market that can lead people to make poor investment decisions.
The makeup of the S&P 500 is constantly changing 🔀
Passive investing is a concept usually associated with buying and holding a fund that tracks an index. And no passive investment strategy has attracted as much attention as buying an S&P 500 index fund. However, the S&P 500 — an index of 500 of the largest U.S. companies — is anything but a static set of 500 stocks.
The key driver of stock prices: Earnings💰
For investors, anything you can ever learn about a company matters only if it also tells you something about earnings. That’s because long-term moves in a stock can ultimately be explained by the underlying company’s earnings, expectations for earnings, and uncertainty about those expectations for earnings. Over time, the relationship between stock prices and earnings have a very tight statistical relationship.
Stomach-churning stock market sell-offs are normal🎢
Investors should always be mentally prepared for some big sell-offs in the stock market. It’s part of the deal when you invest in an asset class that is sensitive to the constant flow of good and bad news. Since 1950, the S&P 500 has seen an average annual max drawdown (i.e., the biggest intra-year sell-off) of 14%.
High and rising interest rates don't spell doom for stocks👍
Generally speaking, rising interest rates are not welcome news for the economy and the stock market. They represent higher financing costs for businesses and consumers. All other things being equal, rising rates represent a hindrance to growth. However, the world is complicated, and this narrative comes with a lot of nuance. One big counterintuitive piece to this narrative is that historically, stocks have actually performed well during periods of rising interest rates.
How stocks performed when the yield curve inverted ⚠️
There’ve been lots of talk about the “yield curve inversion,” with media outlets playing up that this bond market phenomenon may be signaling a recession. Admittedly, yield curve inversions have a pretty good track record of being followed by recessions, and recessions usually come with significant market sell-offs. But experts also caution against concluding that inverted yield curves are bulletproof leading indicators.
How the stock market performed around recessions 📉📈
Every recession in history was different. And the range of stock performance around them varied greatly. There are two things worth noting. First, recessions have always been accompanied by a significant drawdown in stock prices. Second, the stock market bottomed and inflected upward long before recessions ended.
In the stock market, time pays ⏳
Since 1928, the S&P 500 generated a positive total return more than 89% of the time over all five-year periods. Those are pretty good odds. When you extend the timeframe to 20 years, you’ll see that there’s never been a period where the S&P 500 didn’t generate a positive return.
What a strong dollar means for stocks 👑
While a strong dollar may be great news for Americans vacationing abroad and U.S. businesses importing goods from overseas, it’s a headwind for multinational U.S.-based corporations doing business in non-U.S. markets.
Economy ≠ Stock Market 🤷♂️
The stock market sorta reflects the economy. But also, not really. The S&P 500 is more about the manufacture and sale of goods. U.S. GDP is more about providing services.
Stanley Druckenmiller's No. 1 piece of advice for novice investors 🧐
…you don't want to buy them when earnings are great, because what are they doing when their earnings are great? They go out and expand capacity. Three or four years later, there's overcapacity and they're losing money. What about when they're losing money? Well, then they’ve stopped building capacity. So three or four years later, capacity will have shrunk and their profit margins will be way up. So, you always have to sort of imagine the world the way it's going to be in 18 to 24 months as opposed to now. If you buy it now, you're buying into every single fad every single moment. Whereas if you envision the future, you're trying to imagine how that might be reflected differently in security prices.
Peter Lynch made a remarkably prescient market observation in 1994 🎯
Some event will come out of left field, and the market will go down, or the market will go up. Volatility will occur. Markets will continue to have these ups and downs. … Basic corporate profits have grown about 8% a year historically. So, corporate profits double about every nine years. The stock market ought to double about every nine years… The next 500 points, the next 600 points — I don’t know which way they’ll go… They’ll double again in eight or nine years after that. Because profits go up 8% a year, and stocks will follow. That's all there is to it.
Warren Buffett's 'fourth law of motion' 📉
Long ago, Sir Isaac Newton gave us three laws of motion, which were the work of genius. But Sir Isaac’s talents didn’t extend to investing: He lost a bundle in the South Sea Bubble, explaining later, “I can calculate the movement of the stars, but not the madness of men.” If he had not been traumatized by this loss, Sir Isaac might well have gone on to discover the Fourth Law of Motion: For investors as a whole, returns decrease as motion increases.
Most pros can’t beat the market 🥊
According to S&P Dow Jones Indices (SPDJI), 59.7% of U.S. large-cap equity fund managers underperformed the S&P 500 in 2023. As you stretch the time horizon, the numbers get even more dismal. Over a three-year period, 79.8% underperformed. Over a 10-year period, 87.4% underperformed. And over a 20-year period, 93% underperformed. This 2023 performance follows 13 consecutive years in which the majority of fund managers in this category have lagged the index.
Proof that 'past performance is no guarantee of future results' 📊
S&P Dow Jones Indices found that funds beat their benchmark in a given year are rarely able to continue outperforming in subsequent years. For example, 334 large-cap equity funds were in the top half of performance in 2021. Of those funds, 58.7% came in the top half again in 2022. But just 6.9% were able to extend that streak through 2023. If you set the bar even higher and consider those in the top quartile of performance, just 20.1% of 164 large-cap funds remained in the top quartile in 2022. No large-cap funds were able to stay in the top quartile for the three consecutive years ending in 2023.
The odds are stacked against stock pickers 🎲
Picking stocks in an attempt to beat market averages is an incredibly challenging and sometimes money-losing effort. In fact, most professional stock pickers aren’t able to do this on a consistent basis. One of the reasons for this is that most stocks don’t deliver above-average returns. According to S&P Dow Jones Indices, only 24% of the stocks in the S&P 500 outperformed the average stock’s return from 2000 to 2022. Over this period, the average return on an S&P 500 stock was 390%, while the median stock rose by just 93%.