How to Bet After a Hot Market (Part 2: The Hype Stocks)
Will it ever end?
In January, I described 2024 as a “hot market” fueled by momentum and growth. My conclusion was a decision between two different types of bets, based on the continued growth of AI spending:
1. A big bet on momentum. High priced stocks grow into their valuation or just keep getting more expensive. Large cap growth continues to outperform.
2. A bet that the “left behind” stocks catch up to the winners. The market begins to recognize that valuation matters. Small cap value outperforms.
So far this year, “momentum” would be the winning bet, but it has gone beyond AI. The year has been defined by what I would call “hype stocks”:
In healthcare, we have the rise of the GLP-1 Agonists, also known as the weight loss drugs, made by Novo Nordisk (NVO) and Eli Lilly and Company (LLY). But neither of these companies have done well this year — it was Hims & Hers Health (HIMS) that saw the most benefit, using its “online doctor” platform to sign people up for weight loss drugs. This company was producing its own generic version of NVO’s Wegovy, which led to NVO canceling their partnership and accusing HIMS of violating the Wegovy patent. Despite such a critical piece of the business coming under threat, HIMS stock has doubled over the past year.
In the space market (literally space), there is Rocket Lab (RKLB) designing and launching rockets, and AST SpaceMobile (ASTS) building a satellite phone service. Both of these companies are extremely speculative, but they have been market favorites — RKLB stock has returned more than 450% over the past year on the promise of better rockets, while ASTS has tripled on the promise that revenue will come when the entire satellite network is complete.
Nuclear energy companies Oklo Inc. (OKLO), NuScale Power Corporation (SMR), and NANO Nuclear Energy (NNE) are even more speculative. They are effectively bets on promises that projects will be completed. SMR has negligible revenue, while OKLO and NNE show this:
No revenue, yet each company has achieved stock returns of more than 75% over the past year, with OKLO returning more than 450%. And this is with no revenue, only plans and promises.
Quantum computing stocks are somehow even more speculative because of the experimental nature of the technology. But the stock returns have been eye-catching: IonQ, Inc. (IONQ) is up around 250% over the past year, while Rigetti Computing, Inc. (RGTI) and D-Wave Quantum Inc. (QBTS) have both gained about 2,500% over the past year. Massive short-term returns, yet almost all of this industry’s potential use cases are still in the research phase.
Then there are companies with established places in their market, such as Palantir Technologies (PLTR), which provides database support for government agencies, Reddit (RDDT), a very popular social media platform, and Robinhood Markets (HOOD) a broker that is popular among new investors. These are all fast-growing companies, so the price to sales (P/S) metric is a reasonable standard. Here’s how they look right now:1
HOOD: P/S of about 35.
RDDT: P/S of about 25.
PLTR: P/S of about 130!
The type of growth needed to justify these prices goes beyond extreme (this is price/sales, not price/earnings). Good companies, but still hype stocks.2
This is not a concern for the broader market — there will always be “hype stocks” — but there are other issues. Let’s go back to the view from January:
The result of these differences [between growth and value, large cap and small cap,] is a level of concentration that the S&P 500 market index has rarely seen before — the Magnificent 7 group of companies makes up more than 30% of the index, and the top 25 stocks make up about half of the index. The other result is a historically expensive market, with a P/E close to 30 for the S&P 500 (the long-term historical average is about 19).
The same trend has continued. The P/E for the S&P 500 is still around 30, but it has become even more concentrated: Now it is the top 5 companies that make up about 30% of the index, while the top 10 companies represent about 40% of the index value.
This is still a market that is historically expensive3 and historically concentrated. Passively owning the S&P 500 means making a big bet on AI tech.
The economic viewpoint is also mixed: Manufacturing and construction are already signaling a potential recession, freight shipments are declining, and the job market has stagnated. At the same time, U.S. companies are mostly eating tariffs (especially auto makers), which will eventually be passed on to consumers…
In the big picture, it looks like AI investments have continued to be the strongest force behind both the market and the economy. Some of it is speculation based on promises that may not come true, but some of it is real investments that will make real long-term returns. But in both cases, there are two big questions:
How long will the money last?
Who survives when it runs out?
From what I’ve seen, AI investment backlogs are already planned for more than a year, with several of the companies that I follow reporting more demand than they can fill. I could see real AI investments going on for another 2-5 years.
On the other hand, I am concerned about investors’ focus on hype stocks, high valuations, and the impact of a highly concentrated market — these can be signs of a dangerous investment environment. I am also concerned about the economic weakness showing up in some consumer-oriented industries, as well as the broader economy. If growth drops off while valuations decline, then we’ll see two big negatives hit at the same time.
Setting aside the themes and market conditions, I still consider high quality companies (at the right price) to be the best long-term bets, even if they are not the most exciting. It’s just a matter of where you want to look.
Numbers from TIKR.
For a sobering comparison, Zoom Communications (ZM), the videoconferencing company that became popular during the pandemic, spent most of 2020 and 2021 at a P/S above 30, peaking at over 155. The stock is down more than 80% since its peak 5 years ago.
19 out of 20 separate valuation metrics are at “above average” level. Above average valuations are not bad by default, because the quality of the companies in the index is also higher than the historical average. But finding the right interpretation is still difficult, and good companies are still vulnerable to economic changes.