5 Things Every Investor Should Know About This Market Before Buying Anything
Key Points
After the S&P 500's strong performance in the past decade, there is chatter now about its current valuation.
There's no reason to believe that technology companies won't continue to dominate in the future.
But with earnings season getting into full swing, investors should expect surprises and near-term volatility.
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In the past decade, the S&P 500 index (SNPINDEX: ^GSPC) registered a total return of 303% (as of April 17). On an annualized basis, the 15% gain is significantly higher than the market's long-run historical average. With a stellar performance like this, it might encourage anyone to seriously consider putting money to work.
But first, it's important to gain a better understanding about this market before buying anything. Here are five things every investor should know.
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1. The S&P 500 is historically expensive
After the benchmark's strong gains in the past 10 years, there has been a lot of discussion about the market's current valuation. The S&P 500 index trades at a CAPE ratio of 40.4 today. In the past 155 years, it has been higher only during the dot-com bubble period. Data is clear that higher starting valuations result in subpar returns going forward.
The counterargument is that currency debasement, resulting from substantial fiscal and monetary stimulus since the Great Recession, has been a key contributor to rising asset prices. M2 money supply in the U.S. has climbed 167% over the trailing 16-year period. It's ridiculous to think this has not had a profound impact on stock market performance.
2. Tech companies are the stars of the show
Today's stock market is dominated by technology companies, namely the "Magnificent Seven." According to research from The Motley Fool, these stocks represent about one-third of the S&P 500's market value. There's no reason to believe these kinds of businesses won't continue to attract the most attention among investors and drive returns in the future.
Even at their massive scale, these companies generally still possess impressive growth potential. They are highly profitable, benefit from powerful network effects, and have global user bases.
3. Free-flowing information means that narratives matter
This next point is somewhat related to the first factor about valuation. It's becoming increasingly difficult to assess whether a stock is cheap or expensive. That's because with information flowing so freely thanks to the advent of the internet, coupled with the fact that retail investors represent a bigger share of the stock market, it's obvious that narratives matter more than ever.
Tesla provides the perfect example. Its automotive operations have exhibited slow growth and declining margins in the past couple of years. However, the electric vehicle (EV) stock trades at a nosebleed price-to-earnings ratio of 372 simply because Elon Musk is an excellent storyteller.
4. There's always uncertainty
It seems that investors are always on edge these days. That's because there is no shortage of things to worry about. It's easier to be pessimistic than optimistic.
Recently, we've witnessed ongoing trade wars and geopolitical tension grab headlines. Earlier this decade, there's been a global health crisis, surging inflation, and rapidly rising interest rates. And now that artificial intelligence (AI) has entered the chat, investors are concerned about pending disruption.
The truth is that uncertainty is perhaps the most certain aspect of the stock market and economy. Knowing that it's just the natural state of things can support a better mindset, which is key to investing success.
5. Earnings season will lead to volatility
We are about to enter the heavy slate of first-quarter earnings season. And investors can't wait to get fresh updates from the companies that they own or are interested in. If there are any surprises, this could lead to notable swings in share prices.
Volatility impacts even the largest businesses. Netflix is a $411 billion company, but its share price dropped 9% immediately after it reported Q1 financial results. The market might have been disappointed with guidance.
Right now, there is so much attention on how much money is being spent by tech titans on capital expenditures related to their AI ambitions. If a company misses profit estimates, raises spending forecasts, or hints at revenue growth slowing, it wouldn't be shocking to see a sizable sell-off.
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Neil Patel has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Netflix and Tesla. The Motley Fool has a disclosure policy.
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