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Dear Reader,

When investing feels “easy” because every participant is winning, being a voice of sense and sanity is an unrewarded job. Few will listen and fewer will take action, but that’s what market tops look and feel like: caution and reason are thrown to the wind as unwary beginner investors flood the market with buy orders.

I’m reminded of a headline back in 2006 before real estate came to a screeching halt ushering in the “Great Recession” that read “Goo Goo for Real Estate.” It was at that very time that I knew we were at the beginning of the end of a massive credit bubble that was on the verge of popping.

What most of these traders don’t understand is how important breadth is as a gauge of a bull market’s sustainability: is there broad participation among a variety of stocks or are a small handful of high-flyers propping up the S&P 500? Remember that it’s an index comprised of 500 stocks, so the burden shouldn’t fall on a small number of tech stocks.

Even so, that’s exactly what’s happening today. We live in a time when every IPO is an over-hyped, billion-dollar “unicorn” and practically every earnings report in the tech sector is a huge “beat,” though this is more reflective of low analyst expectations than the companies’ actual revenues.

Incredibly, just five companies – Facebook, Amazon, Google, Apple, and Microsoft – make up 18% of the S&P 500’s market cap. In other words, five companies collectively have the same market capitalization as 282 other companies in the S&P.

The fact that these five stocks are in the tech/Internet sector should remind us of the Dotcom bubble of 2000 when companies like Pets.com were the “unicorns” of the day with negative net earnings and sky-high valuations. At one point, the tech-heavy NASDAQ Composite index was up 400% and its price-to-earnings ratio was a mind-blowing 200.

We now know in hindsight that the Dotcom bubble burst dramatically, with the most overpriced tech stocks getting hit the hardest. As the old saying goes, “The bigger they are, the harder they fall” – and when market breadth is narrow, the fall can be especially painful for anyone who bought near the top.

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Another historical example would be the blowup of the Nifty 50, which were the high-growth stocks of the 1960s and 1970s. In 1972, the Nifty Fifty’s average P/E ratio was 42 and when these stocks rolled over in 1973, it didn’t feel so “nifty” when reality set in and a prolonged bear market commenced.

This is a cycle that’s easy to identify, but most market participants won’t acknowledge it until it’s too late: it’s the mania phase in which companies’ fundamentals are ignored and the idea of value is mocked or hated. It’s a time when investors depend on a small number of market darlings to carry the weight of indices and ETFs containing hundreds of stocks. The longer this goes on, the more tragic the ending will be.

As I referenced earlier, another sign of the topping process is IPO mania: start-ups like WeWork enter into the fray with massive capital infusions from enterprising hedge funds only to disappoint investors as they realize that hype and hope are no replacement for profits.

The scales are also unbalanced on a macro level, as the collective market cap of American stocks has reached an extreme level compared to the nation’s GDP, which is a measure of what we’re actually producing. As you can see, this imbalance is now worse than it was prior to the Dotcom crash.

With the S&P 500 returning 29% last year and the historical average being 8% to 10%, index fund investors need to be realistic about how much they can expect to earn going forward. They also need to brace themselves for a return to volatility, with extreme boom-and-bust cycles occurring faster and more frequently – typical pre-contraction market behavior.

This volatility will be exacerbated by the fact that so few stocks control the market. With so much resting on the shoulders of five stocks, a run-of-the-mill correction in those stocks could tank the market as a whole. Algorithms’ stop-losses would get triggered, and what should be a normal correction would devolve into bedlam.

ETFs and mutual funds, which are primary drivers of the stock market nowadays, would tank very quickly in this scenario. The so-called “alternative assets” I’ve been recommending all along will suddenly be the “darlings” of the financial media – with the manic phase behind us, we can start the cycle all over again.

Prosperous Regards,
Kenneth Ameduri
Chief Editor, CrushTheStreet.com

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