US stocks have been climbing, almost uninterrupted, since the April sell-off and the S&P 500 index is up 30% since 7 April.
Bearing in mind that liberation tariffs caused a 10% drop, the rally puts the index 12.2% higher since the start of the year.
These gains come on top of a cumulative 56% gain in the prior two years, and come despite US liberation day tariffs overturning a century of free trade policy and the disruptions they have caused to global manufacturers.
Figure 1: Performance of the broad S&P 500 and the tech-heavy Nasdaq 100 indices year-to-date
The driver has been an AI boom. A massive bet that today’s impressive, but far from perfect, AI models will generate huge cost savings and drive growth and become embedded into all aspects of daily life.
Even if that proves to be a mirage, firms are betting that AI will revolutionise business and productivity like the internet, or the steam engine.
Investors are gauging the pulse of this boom by tracking the corporate earnings of the Magnificent Seven
The bet is sucking in trillion-dollar investment, as the largest companies and richest nations spend eye-watering amounts in R&D and on building the infrastructure necessary to bring this revolution about. The winners are expected to take all – hence no expense is spared.
Investors are gauging the pulse of this boom by tracking the corporate earnings of the Magnificent Seven—Amazon, Apple, Google, Meta, Microsoft, Nvidia, and Tesla.
These have been growing rapidly, beating expectations almost every quarter; they have rewarded this earnings expansion with more investment. The Mag Seven now make up 30% of the US market by value and they account for over half of this year’s market gains.
Figure 2: Performance of the ‘Magnificent Seven’ stocks year-to-date
But this tech-driven rally has been just that. Peel away the surface and many other sectors have lagged, even languished.
IT, communication services and utilities have outpaced the market – industrials, financials and materials have kept pace, but energy, health care and consumer staples have remained flat (less than 4% gain).
Also, small companies have outperformed their larger counterparts, up 19% and 13% respectively. The market has done well overall, but this masks a significant divergence among sectors.
Figure-3: Comparative performance of various US equity sectors year-to-date
Which gets us to valuations. Are US stocks overpriced?
Yes, and on every level of analysis. Stocks are trading around 25 times their earnings in the past 12-months, levels we have not seen since the dot.com boom in the 1990s, which has become the closest go to yardstick.
In contrast to other developed markets, our valuation model singles out US equities for deteriorating monetary conditions
That puts the earnings yield on equities around 4% just below the 10-year treasury bond rates at 4.03%, meaning investors are not asking for much of a premium for risking their capital in the stock market compared to what they could earn almost risk-free. It is not just valuations that stand out.
In contrast to other developed markets, our valuation model singles out US equities for deteriorating monetary conditions, and high price momentum as well.
But of course, equities provide earnings growth which bonds do not. So how do today’s prices compare to future earnings? Not that great.
Stocks are trading at 22.3 times forward operating earnings as of Friday’s close, after a pull back from 23x, and only in the peak years of the dot.com bubble did we go higher, way higher, all the way to 50 times.
Hence the talk of richly priced stocks by the Federal Reserve chair Jerome Powell and a “good bubble” in AI by Amazon’s CEO Jeff Bezos among other heavy weights.
This does not mean we should convert to cash and run for the hills, however. There will inevitably be a correction, but no one knows when.
What the current market calls for is a slightly more defensive positioning; coupled with a broad diversification
The market is not that off kilter, so there is more room for gains. US economic growth has exceeded expectations in the first half of the year, consumer spending continues to grow and the Federal Reserve is expected to cut interest rates further.
What the current market calls for is a slightly more defensive positioning; coupled with a broad diversification, as the winning bets of today might not even reach the finish line.
Everyone was betting Cisco would be the largest company in the world in the dot.com era and Vodafone was also a top bet.
Both fell by the wayside as Amazon and Google whizzed by to become today’s $3tn titans.
The same may happen again, hence the need for diversification, which will help catch those winners, while being less affected by the possible fall of today’s titans.
Charles Younes is deputy chief investment officer at FE Investments
