Why You Must Understand What You’re Trading

When it comes to the major indices, most investors are familiar with the importance of just a handful of stocks…

Stocks like Meta (formerly Facebook), Alphabet (Google), Apple, Microsoft, Amazon, and Tesla all have a massive influence on how those indices perform and where investors park their money.

Not only do millions of investors buy shares in each of these directly, but each of these stocks can be found in a variety of exchange-traded funds (ETF). For example, Apple is included in around 320 different ETFs in the U.S. alone.

That makes many of those ETFs vulnerable to a correction in Apple…

However, add in the hundreds (or thousands if you consider global holdings) of ETFs holding these other high-profile stocks, and you have a massive concentration of risk that many investors simply aren’t aware of, or choose to ignore.

And that has major ramifications for the market when you consider the amount of money involved…

Now, due to the popularity and growth of ETFs, 2021 marked the first year that funds flowing into ETFs globally have exceeded $1 trillion. That means the nearly $10 trillion global ETF market has doubled in just three years.

Should the market change the way it values these companies – for example, due to a rise in interest rates or being de-rated to lower growth – then it would become increasingly difficult for them to retain their lofty valuations…

Especially when you consider one of the most common metrics used to value stocks – the price-to-earnings (P/E) ratio. That’s the stock price divided by its earnings per share. It tells you how many years of earnings it would take to match the current share price.

The P/E ratio gauges investors’ perception of a company’s earnings potential. The higher the P/E ratio, the higher they believe that earnings growth will be.

However, when you consider that Microsoft has a P/E of around 40 (when I started trading it the P/E ratio was around 7 or 8)… and Amazon is around 65 (not to mention Tesla in the hundreds), they are all clearly priced for extraordinarily high growth.

Sure, Microsoft is an infinitely bigger company now than it was back then. It also enjoys a much deeper and diverse income flow too.

But when the market applies a P/E ratio at so many multiples above historic levels, that makes them extremely exposed – not only should those earnings begin to slow – but investors’ perceptions of what that growth might be can also change.

If that earnings perception does a U-turn, then those ultra-high P/Es could quickly fall… meaning not only those stocks, but all the hundreds of ETFs they’re included in would also be due for a correction.

The trap for investors is that they believe because of their sheer size and scale, these high-profile mega-cap stocks are as safe as holding a utility.

However, because they’re not being priced like utilities – their P/E ratios trade several multiples higher than utilities – then these stocks (and the broader market) will feel the full brunt when investors change their mind on earnings growth and interest rates start to tick higher.

So investors who blindly hold broad-based ETFs and think they’re safe because they’re “buying the market” need to really rethink their risk.

In reality, the success (or not) of their investment depends on just a handful of stocks. And those P/E ratios are telling us that the value of those stocks are already over-extended.

Regards,

Larry Benedict
Editor, Trading With Larry Benedict

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