Don’t Let FOMO Take the Reins
Before pulling back on mixed economic data and renewed tariff fears on Friday, the S&P 500 notched two all-time highs last week. Fear of Missing Out (FOMO) may very well be helping to drive stocks higher, but investors would do well to pay close attention to risks to company fundamentals. Policy, economic, and geopolitical risks have risen considerably and, if realized, could alter corporate sales, profit margins, and earnings. These risks will do battle with the secular growth drivers creating advantages for select industries and companies. This is a time to drop the FOMO reins, to avoid investing in the market as a whole, and instead to look for value outside of the shiny objects that have thus far captured investor attention.
Policy risks include both those with beneficial impacts (less regulation, lower taxes) and the less savory sort (tariffs, deficit and debt increases). The Economic Policy Uncertainty Index (from Baker, Bloom and Davis) is a US news-based metric for tracking those policy risks. A look at the chart below shows that in the last twenty years, it has only been higher during the Great Financial Crisis and the COVID-19 pandemic.
Economic Policy Uncertainty Index
Source: Bloomberg, LLC.
President Trump’s remarks last week, suggesting tariffs of up to 25% on autos, semiconductors, and pharmaceuticals, made those policy-related risks more concrete, and market indexes pulled back. Even though the implementation of tariffs has, to date, been far more limited than those threatened, substantial tariffs are set to take effect in coming months unless negotiators find alternative mechanisms to achieve the aims of this administration. Many of these tariffs (such as on steel, aluminum, chips, auto parts, etc.) raise production costs for goods ultimately sold to final consumers here in the US. Companies know very well that they will face limits to their abilities to pass these tariffs through to customers in the form of higher prices. And that means that those companies would see a hit to profit margins. Margins have already fallen following peak levels achieved during the post-COVID recovery. They have stabilized since then, but would be headed lower should tariffs on inputs come anywhere near those floated by President Trump. There will be winners, too, and they are the US companies being protected from foreign competition. Investors would do well to lean into the potential winners and reduce exposure to the potential losers.
Beyond tariffs lie other sources of risks (immigrant labor supply, inflation, interest rates, federal deficits and debt, geopolitical, etc.). And yet the S&P 500 is trading at a valuation well above its historical average (21.9x vs 16.9x), while risk (as measured by the Chicago Board of Options Exchange Volatility Index, or VIX) is priced below average (18 vs 20), but has been climbing recently.
S&P 500 12-Month Forward P/E and the VIX
Source: Bloomberg, LLC
Despite the potential risks, the economic data out of the US remains mostly solid, although weak PMI numbers and slightly elevated inflation causes some concerns. Nevertheless, jobless claims continue to be muted, overall unemployment remains low, business capital spending plans are improving, and retail sales remain strong. The Atlanta and Dallas Fed forecasts place first quarter real GDP growth between 2.3% and 2.5%. This creates a firm foundation for business. In addition, several strong growth drivers remain in place in select industries. Innovation enabled by artificial intelligence, for example, is just getting underway, and while current winners are those providing the picks and shovels for AI models, we are beginning to see more applications adopted around the economy, from industrial companies (improving factory automation) to agriculture (smarter crop cultivation and harvesting) and to whole swaths of the services sector. While the S&P 500 trades at a high multiple, this spreading of innovation could very well elevate valuations for companies beyond current market leaders, allowing for a broadening of the market’s strength. But that also means that some past winners could underperform and since those dominate market-capitalization-weighted induces, such as the S&P 500, the “market” may struggle from here.
But investors need not invest in the whole market, and here at ACM we deliberately steer clear of such an indiscriminate approach. While the largest ten stocks in the S&P 500 are trading at steep multiples (29 times forward earnings), the remaining 490 or so are trading at a more reasonable 19 times. While this is still above historical averages, the premium is less than that on the top 10 and less than that on the market as a whole. Given the brewing risks, we think it important to avoid FOMO, and instead prefer to find value. The underlying strengths in the US economy continue to suggest a healthy backdrop for equity investors, provided they are selective.
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