The legendary Nifty Fifty basket of stocks was identified by the Morgan Guaranty Trust and others in the early 1970s. These were famous names that were the premier growth stocks of their day, with continually increasing dividends, according to Jeremy Siegel of the University of Pennsylvania (1998). Supposedly they were "single-decision" stocks, i.e., you could just buy them and hold them forever, because they would "always" grow. But then the great bear market of 1973-74, and the bear markets of 1980-82 and 1987 followed, with huge drawdowns for many of the Nifty Fifty stocks. For example, Avon Products (NYSE:AVP) dropped 86% in the 1973-74 bear market, and Xerox (NYSE:XRX) fell 71%. Polaroid, which eventually went under, dropped 91%, according to Beacon Asset Managers.
The lesson for many investors was that the high valuations (i.e., average P/E ratios = 41.9) of these 50 stocks in 1972 should not have been ignored, because much pain and large paper losses soon followed. However, Jeremy Siegel's 1998 paper appears to have lent new support to the claim that the Nifty Fifty should have been held forever, regardless of market timing. This is because, by his calculations, the average return through 26 years to 1998 was 12.2% annually for the Nifty Fifty, which was only slightly less than the 12.7% annual return from the S&P 500 over that time period. On the face of it, this is an outstanding outcome.
However, Prof. Siegel failed to mention that inflation rates reached 8.2% annually in the decade from 1972 to 1982, according to the Ibbotson Associates Stocks, Bonds, Bills, and Inflation 2002 Yearbook. This means that on a real-return basis, the S&P 500 made only about 8.5% annually from 1972 to 1998 -- admittedly a minor point, but worth knowing. So by comparison, the Nifty Fifty also did well in nominal terms, but not quite so well as advertised in real terms. Not to mention the fact that the 1973-74 bear market saw a maximum drawdown of 45.08%, the 1980-82 bear market saw a 23.79% maximum drawdown, and the 1987 bear market saw a maximum drawdown of 30.17%.
This means that investors were sorely tested psychologically, and I'm quite sure that many did not hang on through all of these bear markets. In my opinion, saying that investors would have been better off to use a buy and hold strategy suggests that most people would have or could have tolerated a 45% loss, right after buying the Nifty Fifty in 1972. Note (Chart 1) that they would have had a negative Holding Period Return ("HPR") every year for eleven straight years!
Suggesting that investors should have withstood this kind of disappointment for this long is absurd. Clearly Prof. Siegel has never had to deal with the public. On what basis could such a buy and hold strategy have been justified in real time during those eleven years? In my opinion, it should only have been considered after the valuations had dropped quite precipitously in the 1973-74 bear market, or about two years after peak valuation was reached in 1972. Chart 2 shows that the P/E ratio for the S&P 500 dropped from around 19 in 1972, to only about 10 at the beginning of 1975.
Chart 1: Effect of Inflation and 1973-74 Bear Market on S&P 500 Returns
Source: Author; Matthew Timpane; Data from Ibbotson Associates, 2002
Chart 2: P/E Ratio Time Series for S&P 500
So although Prof. Siegel's data show that one could have fared well even if the Nifty Fifty were bought at the top (and held for 26 years), I still have a question. What would have happened if one had instead taken due note of the extreme valuations for the Nifty Fifty in 1972, and waited to buy them until those valuations dropped back to more normal, or even cheap levels? Chart 3 shows that the HPR for the S&P 500 starting in 1975 would have been positive for every one of the next 24 years, allowing investors to completely miss the discouraging eleven year stint of negative HPRs they would have experienced by buying at the top in 1972. Not only that, their total rate of return (HPR) as of 1998 would have increased by about 3.3% per year, to about 17.1% annually.
Chart 3: Effect of Inflation and Market Timing on S&P 500 Returns
Source: Author; Matthew Timpane; Data from Ibbotson Associates, 2002
Many articles have been written about the Nifty Fifty since Prof. Siegel's paper came out in 1998. A number of these have gone back and reviewed performance, just like he did. For example, Tim McAleenan Jr. listed the performance of each individual stock from 1971 to 2016. It is interesting to note that three companies (Polaroid, Kresge/K-Mart, and MGIC) went under, and two more nearly disappeared (Emery Freight and Eastman-Kodak) and were either absorbed by another firm or spun off a company that outlasted them. Three more had low or negative returns: Burroughs became Unisys (NYSE:UIS), but lost 6.32% annualized from 1971 to 2016, while Avon Products made only 2.0% annually; First National City Corp. became Citigroup (NYSE:C) but has made only 3.8% annually; and Xerox made only 4.1% annually. Offsetting these are some spectacular successes: Wal-Mart (NYSE:WMT) has made 18.6% annually, and Lubrizol, now part of Berkshire Hathaway (NYSE:BRK.B), has made 14.7% annually. McDonald's (NYSE:MCD) has made 15.7% annually, and Phillip Morris, now Altria (NYSE:MO) has made 19.2% annually. An article at moneyweek.com by Cris Sholto Heaton in 2010 illustrated the sector performance of the Nifty Fifty from 1972 to 2001, based on work done by Prof. Siegel and two other academics (Fesenmaier & Smith, 2002) at Pomona College (Chart 4).
Chart 4: Sector Returns for the Nifty Fifty 1972-2001
The academic study in 2002 by Jeff Fesenmaier and Gary Smith of Pomona College showed that since the Nifty Fifty were never clearly defined, and since Prof. Siegel's claims about performance rely on the Morgan Guaranty list, which included a number of lower P/E stocks, then Siegel's performance story is weakened a bit. This is because the point of the Nifty Fifty story was high P/E growth stocks. An alternative list was published by Kidder Peabody based on higher P/E ratios. Indeed, if one compares the performance of higher and lower P/E stocks from the Morgan Guaranty list, a divergence in performance is observed, with higher P/E stocks underperforming lower P/E stocks, according to the Pomona College study. There are only 24 stocks that appear on both the Kidder Peabody and the Morgan Guaranty lists. These may be considered the true components of the Nifty Fifty that are uncontroversial. Total nominal returns for these 24 stocks in aggregate were 9.69% annually through 2001, or only about 54% of the cumulative return delivered by the S&P 500. When the entire Kidder Peabody list is considered, there was a significant negative correlation (r = -0.41) between P/E ratios in 1972 and subsequent performance over 29 years (Chart 5).
Chart 5: Negative Correlation Between Kidder Peabody List's P/E and Total Returns 1972-2001
Source: Fesenmaier and Smith
If we examine the Kidder Peabody - Morgan Guaranty Nifty 24 stocks today, we can see that they are still formidable holdings. Although only 19 of the 24 stocks survive, their hypothetical returns in a buy-and-hold strategy over the last ten years would have produced a 9.63% total return annually, compared to 7.75% for the S&P 500, including dividends. However, their maximum drawdown in 2008-09 would have been around 43%, almost exactly the same as the S&P 500. In comparison, the Morgan Guaranty Nifty Fifty survivors, which now number 39, would have produced a hypothetical total return of only 8.79% annually over the last ten years, with a maximum drawdown in 2008-09 of about 47%.
A revised list called the New Nifty Fifty was proposed by analyst Charlie Bilello at Seeking Alpha in 2014. This is really 45 mega-cap stocks that were up 5% YTD in June 2014. This group would have made a spectacular hypothetical total return of 14.23% annually over the last ten years, with a maximum drawdown in 2008-09 of about 41%. Yet another Nifty Fifty group was presented by analyst Mike Nadel at Seeking Alpha in October 2014. This group can be called the New Dividend Growth Style Nifty Fifty; its hypothetical performance over the last ten years would have been an outstanding 13.03% annually, with a maximum 2008-09 drawdown of only about 28%. This compares favorably with the Vanguard Dividend Growth Fund (MUTF:VDIGX), which hypothetically returned 9.08% annually, with a maximum drawdown in 2008-09 of about 32%.
Clearly one could have used any of these Nifty Fifty schemes and done well, but those seeking maximum returns would have done better with Charlie Bilello's proposed list, while those seeking the best risk-adjusted returns would have done better with Mike Nadel's proposed list, which had an outstanding Sharpe Ratio of 0.99 for ten years. Charlie Bilello's list had a Sharpe Ratio of 0.81 over ten years, the Vanguard fund had a Sharpe Ratio of 0.68, the Kidder Peabody - Morgan Guaranty 24 list had a Sharpe Ratio of 0.56, and the original Morgan Guaranty list alone had a Sharpe Ratio of 0.51, compared to 0.49 for the S&P 500.
Given the current extreme valuations in the markets (Chart 6), it might behoove investors to delete some names from whichever list they might choose to use. This is based on the negative correlations between long-term performance and P/E established in the Pomona College study and elsewhere. For example, the surviving 39 stocks of the original Morgan Guaranty list could be cut down by 5 more names based on P/S ratios over 6 and/or P/E ratios over 40. The New Nifty Fifty of Bilello could drop from 45 names to 38 based on these criteria. The New Dividend Growth Style Nifty Fifty of Nadel could be cut from 50 names to 37 names on these same criteria. Interestingly, none of the surviving names on the Kidder Peabody - Morgan Guaranty 24 list would need to culled based on valuation extremes.
Chart 6: Market Valuations Using Corporate Net Worth/GDP
Data on the various Nifty Fifty lists suggests that the valuations on these lists could be used as a market barometer. For example, the average P/E ratio for the Morgan Guaranty Nifty Fifty survivors list is 24.21, but four stocks have a P/E over 40: Bristol-Myers Squib (NYSE:BMY), Anheuser-Busch Inbev (NYSE:BUD), General Electric Co. (NYSE:GE), and Newell Brands Inc. (NYSE:NWL); these should be eliminated based on the negative correlation to performance.
The average P/E ratio of the Kidder Peabody - Morgan Guaranty 24 survivors list is 21.51, and there are no extreme valuations. The average P/E ratio for the Bilello New Nifty Fifty is 24.18, and high P/E ratios would eliminate Caterpillar Inc. (NYSE:CAT), Colgate-Palmolive Co. (NYSE:CL), Facebook Inc. (NASDAQ:FB), and Monsanto Co. (NYSE:MON). Nadel's New Dividend Growth Style Nifty Fifty list has an average P/E of 62.87, a very high number, and high P/E ratios would eliminate Becton Dickinson & Co. (NYSE:BDX), Caterpillar Inc. , Colgate-Palmolive Co. , Chevron Corp. (NYSE:CVX), General Electric Co., The Kraft Heinz Co. (NASDAQ:KHC), Kinder Morgan Inc. (NYSE:KMI), and Realty Income Corp. (NYSE:O).
Looking over all of these deletions, and comparing the average P/E ratios for each list, it would appear that parts of the market are over-valued. The suggested deletions mainly come from the Consumer Goods and Industrials sectors. The average valuations of the lists are all high to the market (whose estimated P/E ratio is at 19.35) except for the Kidder Peabody - Morgan Guaranty 24 survivors list. This suggests that the search for yield and safety has pushed stocks high enough to warrant caution going forward. It would appear that the dividend growth strategy that is so popular right now may be over-bought on a massive scale. Although the extremes of 1972 have not yet been met on average for most of the lists, at least 14 stocks from the various lists are already at the kind of extreme valuations seen in 1972. We could see the market go higher from here then, but there are warning signs worth considering. If the average P/E ratios of several more of the Nifty Fifty lists climb above 40, as it already has for one of them, I would venture to say that the jig is up and a great bear market will soon follow (Chart 7).
Chart 7: The Four Worst Bear Markets
It is recommended that investors lower their allocations to risk and increase their allocations to bonds and cash. Adopting Mike Nadel's New Nifty Fifty list from 2014 as one's equity model would fit in with this strategy. It might also make sense to hold some intermediate to long Treasuries: the I-Shares 20+ Yr. Treasury Bond ETF (NYSEARCA:TLT), the I-Shares 7-10 Yr. Treasury Bond ETF (NYSEARCA:IEF), the Vanguard Intermediate Term Bond Fund (NYSEARCA:BIV), the PIMCO Total Return Active ETF (NYSEARCA:BOND), and the I-Shares Core Aggregate Bond ETF (NYSEARCA:AGG); also some defensive sector funds like the Powershares S&P 500 Low Volatility ETF (NYSEARCA:SPLV),and the I-Shares Edge MSCI Minimum Volatility ETF (NYSEARCA:USMV); also some liquid alternatives like the Otter Creek Prof. Mngd. Long/Short Portfolio (MUTF:OTCRX), the AQR Long/Short Equity Fund (MUTF:QLENX), or the AQR Equity Market Neutral Fund (MUTF:QMNIX); and even some sophisticated hedge-like Closed-End Fund strategies like the Nuveen S&P 500 Buy-Write Fund (NYSE:BXMX).
Disclosure: I am/we are long CVX, MCD, BIV, BOND, AGG, OTCRX, QLENX, QMNIX, BXMX.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: This article is intended to provide information to interested parties. As I have no knowledge of individual investor circumstances, goals, and/or portfolio concentration or diversification, readers are expected to complete their own due diligence before purchasing any stocks or other securities mentioned or recommended. This post is illustrative and educational and is not a specific recommendation or an offer of products or services. Past performance is not an indicator of future performance.