- The S&P 500 is up 24% from its October low.
- But almost all of the index’s returns since January can be attributed to a few stocks.
- Bill Smead says this could cause problems for the index once the “mania” is over.
Those who have been on the sidelines of the rally in the past may be tempted to attend.
The S&P 500 is now back in bull market territory riding a 24% gain and nearing its January 2021 all-time high.
But it’s best to ignore the animal spirit inside of you that feeds your envy and fear of missing out, says Bill Smead. That’s what he did in 2020, when ARKK around the world was soaring, and the following year he dabbled in value stocks and crushed the market.
Not chasing the hot spots has worked out well for him on a long schedule. His Smed Value Fund (SMVLX)) have It outperformed 99% of similar funds over the past five years and 97% over the past 15 years, according to Morningstar data. And the founder of Smede Capital Management is betting his strategy will work again amidst the hype about artificial intelligence stocks.
For Smede, it’s clear that this is a speculative episode. Year-to-date, only seven stocks—Apple, Amazon, Tesla, Microsoft, Meta, Nvidia, and Alphabet—have essentially driven overall S&P 500 returns.
Smed Capital Management
That means bad news for the broader exponent once the episode ends, he said.
“Unfortunately, most stock markets will suffer the damage caused by the normal disruption that occurs when this epidemic hits a wall and financial euphoria unwinds,” Smed said in a June 27 memo. wrote in “Fear the stock market failure!”
He compared his concentration on some stocks to other maniacs, including the “Nifty Fifty” era of the early 1970s, the dot-com bubble of 2000, and RCA stocks of 1929.
3 charts showing why the rally is nearing its end
In the memo, Mr. Smede shared three charts that show “how long the enthusiasm for tech stocks, in particular, has lagged behind.”
The first is S&P 500 call option volume, which hit a record high, which means investors are overly bullish on the current momentum.
Smed Capital Management
Second, the combined price-to-free cash flow ratios of the top seven stocks in the S&P 500 are close to 70. This ratio is much higher than it has been in the last decade, as AI-related developments have caused the ratio to spike since the beginning of the year. This means that investors are paying a higher premium relative to current cash flow to hold shares in anticipation of future success.
Smed Capital Management
And third, the tech sector of the S&P 500 is reaching valuation levels last seen during the dot-com bubble. Below, Smede cites the sector’s price-to-earnings ratio (orange line) to account for long-term growth.
Smed Capital Management
Overall picture
Over-enthusiastic investors flocking to AI stocks and poor market spread have been cited as a concern by many strategists in recent weeks.
CIO and Chief U.S. Equity Strategist Mike Wilson said: “Retail and institutional investor sentiment has reached its highest level in more than two years and is among the top quintiles in decades. Sentiment and positioning are totally bullish as a result.” Morgan Stanley said in a June 20 memo: “However, given our fundamental view of growth, we are finding it difficult to get on board with the current excitement and the narrative that underpins it. is.”
Valuations are also a concern, especially with the pressure to build economic growth.
“Investors who have inflated valuations based on expectations of strong earnings growth are seeing slowing earnings in a world where 2- and 10-year yields are above 5% and 4%,” he said. We are likely to struggle with the impact on earnings.” Interactive Brokers senior economist Jose Torres said in a client note on Friday.
The average Wall Street strategist is now bearish about the performance of the S&P 500 index for the rest of the year, given the momentum of the stock market rally since October. The average target is about 4,000, or about 10% below the index’s current level. Out of 4,450.
But if the U.S. economy avoids a recession, stocks could continue to rally, and a wider range of participants could make the rally even stronger. At the moment, the labor market remains strong and the unemployment rate stands at 3.7%.
Whether that is true will become clear in the coming months. But the Federal Reserve’s insistence on keeping rates rising, the bond market signaling future problems, and a slowdown in manufacturing activity suggest a downtrend in the economy is coming. And that could mean the end of AI-driven speculation and, by extension, the rise of the S&P 500.
