After briefly becoming the king of the stock market, Nvidia is suffering huge losses. While this could be a warning sign for investors who are concerned this year's rally is overly dependent on a few big tech names, there are ways to avoid bubble-like prices while still staying broadly invested.
Just last Tuesday, Nvidia briefly overtook Microsoft to become the world's most valuable company. Since then, investors have turned their attention to the company that makes chips for artificial intelligence, causing its shares to fall by about 13% over the past three trading days.
Nvidia's troubles aren't just a potential problem for AI evangelists. Nvidia and other members of the so-called Magnificent Seven club have been driving the bulk of the overall market's gains for the past several years. Tech stocks now account for about a third of the market.
S&P 500,
In 2019, this rate was less than 25%.
Nvidia's valuation — it's trading at about 70 times earnings — suggests the stock could fall further. While price/earnings ratios for the other tech names that dominate the market aren't so extreme, those stocks are also very valuable.
Technology Select Sector SPDR
The exchange-traded fund is trading at 29 times earnings, well above the broader market's 21 times, according to Morningstar.
For investors, the combination of a large index weightage and elevated valuations poses risks. If traders suddenly become displeased with big tech stocks, weakness in that sector alone could be enough to trigger a bear market, independent Wall Street researcher Jim Paulson said.
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“The infamous Mag7 (and perhaps a few other notables) have seen a massive surge in price, and if they fall – given their high weighting – the S&P 500 could decline by more than 20%,” he wrote.
Fortunately, Paulson also said that the top-heavy nature of the market has a silver lining. While Nvidia and other top tech stocks are leading the way, many corners of the market — including materials, industrials and consumer discretionary stocks — have lagged behind. They have averaged annual returns in the low to mid single digits over the past few years.
“Typically, when the S&P 500 is extended and overbought, most stocks in the index enjoy significant participation to the bulls and the S&P shows broad vulnerability to a bear,” Paulson writes. “However, in the contemporary bull market, the concentration has been so intense, most stocks have not participated excessively making the bears' job much more difficult.”
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Today's price/earnings data reflects this dynamic, giving investors wary of valuations like Nvidia's plenty of opportunity to bet on the stock market without getting caught up in the froth. Take a look at the Invesco S&P 500 Equal Weight ETF, which owns roughly equal amounts of every stock in the index, rather than matching the weightings of stocks to their market values, as the S&P 500 does.
The fund's allocation to technology stocks is significant, but not more than 16%. Its portfolio trades at 18 times earnings, slightly below the market's long-term average of 19.
Small-company stocks, which have outperformed large-company stocks in eight of the past 10 years, are another approach.
iShares Russell 2000 ETF
It's even cheaper: Its proprietary stocks trade at just 15 times earnings, on average.
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To be sure, betting on underperforming stocks means investors could miss out on some of the AI-fueled momentum of big tech companies. But when sentiment shifts, the market is less likely to punish stocks whose prices seem easily justified by their quarterly profits.
This will save investors from some major trouble.
Write to Ian Salisbury at [email protected]