Are Stocks Still the Place to Be?

As a rule of thumb, it is better to hold stocks than not to hold stocks. Your expected returns in stocks are around 10% nominal, or 5-6% after inflation. Not much else compares with that, whether bonds, TBills, or gold. REITs (real estate) have historically done similarly to stocks and offer some good diversification, but whether those are a good opportunity today is a topic for another article.

Looking at markets today, there are a couple things that worry me. But that's not to say that stocks aren't still a good investment. In fact, worrying about markets is pretty normal, and the amount of worry investors feel is usually correlated with stocks going higher. You might have heard phrases like, "stocks are climbing the wall of worry," or Buffett's more famous line, "Be greedy when others are fearful." So worry is actually a good thing for forward-looking returns.

Despite stocks breaking new all time highs, there still seems to be a lot of worry out there. And in fact, I'm a bit worried myself!

Here's what I'm worried about today, and you can weigh for yourself if it has any substance. Admittedly, this is just speculation about what could go wrong. Especially the parts about AI companies. I am not an expert in AI, though I am learning what I can about the businesses that are creating and using it.

Worry 1: Diminished diversification within the S&P 500. A relatively large part of the S&P 500 is concentrated in technology. It is by far the largest sector, with a 34.82% weighting. And that's after the S&P 500 decided to treat several "Tech" companies as "Communications Services." If you treat several of these "Communications Services" companies (like Google, Meta, Netflix) as "Tech," tech rises to about 43.98% of the S&P 500. Which is a lot. For reference, the next closest sector is currently Financial Services at 13.53%.

These categories are, of course, artificial. But they offer a useful lens of analysis. The goal of diversification is to own a portfolio of businesses such that a disruption in one area does not affect your other holdings. That disruption could be a new technology, regulatory intervention, changes in consumer behavior, cyberattacks, or anything else.

This becomes important because owning a large allocation of technology stocks may mean that more of your portfolio is impacted by these risks. For example, whether you call it tech or communications, Google has more in common with Microsoft than it does with TJ Maxx or Exxon Mobil. Or even Verizon, a fellow "Communications" stock. If something changed the way we use the internet, Google and its fellow tech giants would be affected far more than TJ Maxx, Exxon Mobil, or Verizon.

Now, will that happen? Or will these companies continue to put up phenomenal returns relative to the rest of the index? I don't know. But it's getting to where a lot of eggs are in that one basket, and that makes me nervous.

Worry 2: Higher Capital Expenditures in Tech. As a rule of thumb, the more capital intensive a company becomes the lower its returns on investment go. This creates a whole host of other problems and risks down the line. Usually, more capital intensive industries are more economically sensitive, lower margin, riskier, and slower-growing. These are not traits I desire for my investments.

Formerly, these companies like Google and Microsoft were extremely "capital light." Most of the value of what they created was via code. Big tech is expected to make $325 billion of investments (such as building data centers and training AI datasets) in 2025, up from $223 billion in 2024. Those are big numbers in themselves, but more concerning to me is the rate of increase. That's a 45.7% increase! Did their revenues grow 45.7%? Will they recoup their investment? How long will that take?

These same companies generate an estimated $600 billion in earnings, and have a combined valuation of roughly $18.9 trillion. While $325 billion sounds like a lot, it's less insane in the context of the cash flow these businesses are already generating. Still, the question remains, will these expenses persist indefinitely or taper off after a few years?

Investors are currently giving these companies the benefit of the doubt. After all, some of these companies are still growing at an impressive rate. For the last 12 months, Microsoft announced revenue growth of 18%, and earnings growth of 24%. Revenue for last quarter was $76.4 billion. These are mind-boggling figures. Even if the capital expenditures are a little excessive in the short term, there seems to be plenty of demand to support them.

Too, it could be that these companies expect to see really high returns from this spending. And if that's the case, they should spend it! But it could also be true that these companies are in tighter and tighter competition with each other to deliver the next big thing. That marks a negative change for these companies because most of them have been immune to competition for much of their histories. That is partly why the returns have been so good. And yet, they're bumping into each other more and more. Google used to be the only real player in search. But now Microsoft has Bing, and more troublesome for Google, a large investment in OpenAI (aka ChatGPT). Google, meanwhile, offers a knockoff version of OfficeSuite, and is integrating AI with it in a very similar way as Microsoft. At some point, the competition could become more intense.

My guess is that these companies will still grow revenue pretty nicely, but that their revenue growth may not match the growth in spending. That means these companies may not be quite as profitable in 5 years as they are today. Less of the revenue their generate will be available to shareholders in the form of dividends. But is that the same as losing money and destroying value for shareholders? No. In fact, investors in these companies could still do well. But I think there's risk here in a way that there doesn't seem to have been in the past.

But Enough Doom and Gloom!

Reason Things May Be Okay 1: In finance there's a concept known as the "equity risk premium." Essentially, it tells you what you might expect to earn in stocks relative to bonds. Currently, it sits at 3.94%. If bonds pay 4.23%, you'd expect a nominal return of about 8.17% by investing in stocks over the next decade. Which is unexceptional, but decent.

Historically, there's been a crude, inverse correlation between the equity risk premium and subsequent returns. As with most statistical correlations in finance, it leaves a lot to be desired. It has an R-squared of just 0.467. In my college chem lab, for comparison, we were expected to produce R-squared of closer to 0.98. Higher is better, because it tells you what how much of the correlation comes from the variable being studied. In a controlled, scientific experiment, you want very, very high R-squared to prove that you've isolated all the other variables. In finance and economics, you can't isolate all the other variables because everything is interconnected and we only have one sample, the past.

But here's the chart anyway.

Data from https://pages.stern.nyu.edu/~adamodar/

Still, you look at this chart and see a few things. One, is that very few 10 year periods since 1961 offer a nominal return below 0%. And relatively few offer a nominal return of less than 5%. So if you're a betting man or woman, stocks are a good place to be.

The other insight is that if you take that regression from earlier (bearing in mind its clumsiness), you see that expected returns would be about 10.05% for the current, estimated equity risk premium.

So what do I expect from stocks for the next decade? Probably about 8-10% annualized returns, 5-6% adjusted for inflation. Which is normal.

But maybe you've heard that stocks today are outrageously expensive. More expensive, in fact, than in the height of the dot-com bubble. Is that true? From what I can see, valuations may be slightly on the high side, but not "bright red, flashing warning light" high. In 1999, the "equity risk premium was just over 2%, which is where it would be if stocks were twice as expensive as they are today. I don't see much merit in the claim that stocks are in some sort of late-90s-esque bubble. Today's equity risk premium of 3.94% is neither historically high nor historically low. Hence, I would expect pretty typical returns.

Reason Things May Be Okay 4: Some people worry that stocks are in the late phases of a bull market. I'm not sure. Usually, when you have a long bear market, like we did from 1999-2009, the subsequent bull market has some serious legs. If we go back in history to 1974, that was another time that stocks had had a rough prior decade. The next 10 years saw returns of 14.78%. The next ten years, from 1984 to 1994 was another good decade, averaging 14.38%. But then, you worry. The 90's! The dot-com crash in 2000. Surely stocks couldn't be up from 1994 to 2004? 12.04% annualized. That's how stocks did from 1994-2004. That's 30 years with an average return of 13.73%, annualized.

So, it's true that we're 15 years into a bull market. But does that mean stocks will crash from here? Not necessarily. I mean, they will definitely crash 20% or more from time to time, but as far as big crashes that take years to recover from, I don't really expect anything too cataclysmic. Remember, bull markets can last 25-30 years. A lifetime for most savers and retirees.

Reason Things May Be Okay 3: As I alluded to earlier, I'm still worried. If I were euphoric and talking about how stocks are the only asset worth owning, how nobody should own any bonds at all, how stocks are going to quadruple over the next decade, then I'd be worried. But, as it is, I'm uncomfortable and I think lots of other investors are uncomfortable. So there's not much left to do but sit tight and watch stocks keep crawling along.