Nvidia’s $3 trillion year: How the AI boom propelled the chip giant

By Ian Salisbury

Stocks have logged a historic run thanks to AI, Nvidia and other growth drivers, but some Wall Street strategists warn the market will spend the next decade feeling winded. While the warnings are worth heeding, there are ways to protect yourself and possibly avoid a "lost decade" for stocks.

Steep valuations and extreme concentration in tech are the main causes for concern, according to Goldman Sachs. The market's cyclically-adjusted price-to-earnings ratio has reached 38 — putting it in the 97th percentile going back to 1930, Goldman noted in an October report. Thanks to tech's big rally — yes, we're looking at you Magnificent Seven — market concentration is in the 99th percentile.

The upshot, Goldman says, is that investors should expect annualized returns of 3%, or 1% after inflation, for the next 10 years.

Goldman is hardly alone in expecting meager gains. Vanguard issued a similar forecast, pegging U.S. stock returns for the next decade at 2.8% to 4.8%. J.P. Morgan strategists predict 5% returns.

Dissenters say the bears are too pessimistic about the dynamic U.S. economy and its growth potential. Economist Ed Yardeni expects big productivity gains, driven by innovations like AI to support the S&P 500's historically high forward price-to earnings ratio, which sits at about 22. And he hasn't backed off his longstanding view that we are in a "Roaring 20s" that will see the S&P 500 hit 10,000 by end of this decade.

"There's sort of a knee jerk belief that the forward P/E should be around 15 — that has / that is the historical average," he says. "The problem with that is that there's nothing in the bible or U.S. constitution that says that the forward P/E has to revert to 15.

The other problem with avoiding stocks due to high valuations is that the market can stay expensive and hold its value; naysayers have been warning that stocks look overvalued for years. GMO founder Jeremy Grantham told Barron's that price-to-earnings ratios appeared frothy as far back as 2014. Meanwhile stocks have continued to climb, partly thanks to waves of tech innovation and other growth drivers.

GMO declined to address its prior forecast and directed Barron's to a commentary from Ben Inker, co-head of asset allocation, pointing out "the most attractive prospective investment opportunities rarely come from past winners, especially when they have been of this magnitude."

Many macro factors influence valuation too, notably interest rates — the lower the better. And while foreign stocks are cheaper, especially in emerging markets, they don't offer up nearly as much earnings growth, making the U.S. a top destination for global asset flows.

Still, there are ways to address the pain points. One solution endorsed by Goldman's analysts is to swap an index fund tracking the S&P 500 for one that weights all 500 stocks the same. While tech stocks make up about 33% of the S&P 500, they represent only 17% of the Invesco S&P 500 Equal Weight ETF. The fund trades at a forward price-to-earnings ratio of less than 18, compared to more than 22 for the standard version.

Investors can accomplish similar goals by moving some holdings into small-cap or value funds, targeting undervalued stocks directly. Bill Nygren, co-manager of the $25 billion Oakmark Fund, says he's found plenty of bargains in sectors like energy and financials, both trading at forward P/Es of less than 18.

ConocoPhillips, Citigroup, and Charles Schwab are among Nygren's favorites. Schwab, which earns a large share of its profits from investing its brokerage customers' cash, has seen its share price suffer after its short-term borrowing costs spiked. That problem is now in the rearview mirror, says Nygren, which should allow its core business to shine.

"Schwab has grown its number of investors faster than any of the large money management platforms," he says. "They have the lowest cost platform, and that allows them to provide investors more services at lower cost."

Small-caps have been a market laggard for years as investors have flocked to large- and mega-caps. Small-caps have lagged behind larger companies eight out of the past 10 years. The iShares Core S&P Small-Cap ETF is up 17% in 2024 — a big gain in a normal year, but nowhere close to the S&P 500. Stocks in the fund's portfolio trade at 17 times forward earnings. In contrast to large-cap stocks, that has / that is about the same level as a decade ago.

Small-caps now have some tailwinds that could propel them for the next decade, according to Jason Alonzo, portfolio manager at Harbor Capital Advisors. A more favorable interest rate climate should help small-caps, along with a regulatory and tax agenda favoring domestic companies, courtesy of the incoming Trump administration. "That's good for small caps," Alonzo says.

One way to avoid pitfalls of the small-cap space — such as betting on companies whose stock prices have been beaten down for good reason — is to focus on quality stocks with steady profits and strong balance sheets.

The iShares MSCI USA Quality Factor ETF and the Dimensional U.S. Small Cap ETF are both potential options.

Foreign markets have their drawbacks, but still offer up bargains. The iShares MSCI EAFE ETF, which tracks developed markets like Japan, U.K. and Switzerland, trades below 14 times earnings, a low the S&P 500 hasn't hit since 2013. While the iShares fund is light on tech — just 10% of the portfolio — plenty of top holdings are international powerhouses that rival some of the strongest U.S. firms, including Ozempic-maker Novo Nordisk, food company Nestle and luxury goods firms LVMH Moet Hennessy Louis Vuitton SE and Richemont.

Luxury goods have struggled, hurt by weakness in China, but LVMH and Richemont — both highlighted in Barron's recent luxury cover — have brands that will endure.

The strong dollar reduces the value of foreign profits for U.S. investors and poses a headwind for foreign-market index funds. If you're looking out a decade, though, what should matter is enduring earnings growth.

Kimball Brooker Jr., co-head of global value at First Eagle Investors, points out that LVMH and Richemont own top-notch international brands with sales in a host of different currencies, providing a natural hedge. "They are operating all over the world," he says. "So there's a bit of embedded protection."

Write to Ian Salisbury at ian.salisbury@barrons.com

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