Not in decades has the market been this hot. Is This Rally Appropriate?
Amid a significant upswing in US stock prices, some investors might be questioning whether this is too good to be true.
Whatever your perspective, the past few months have been spectacular for the S&P 500. Since October's lows, the index has increased by more than 25%, and Henry Allen, a macro strategist at Deutsche Bank, notes that "the current rally is almost unprecedented."
The index has now increased for 15 of the last 17 weeks, a feat that has only been accomplished once in the previous 50 years, in 1989. It would be the first time since 1971 if it records another gain this week—for 16 out of 18.
It's obvious why optimism is so high. Despite positive economic data, inflation has been declining since October's lows. As a result, expectations of future interest rate reductions have increased as the Federal Reserve has become more dovish. Treasury yields have decreased, which lifted stocks.
However, is that really enough to warrant stocks’ surge?
Tom Essaye, founder and president of Sevens Report, writes, "If we look at the facts, I cannot help but feel as though this relentless rally has gone far beyond either actual improvement in the fundamentals and reasonable expectations of continued improvement."
Despite the fact that the market now only expects four interest rate cuts in 2024, down from seven at the end of 2023, no rate cuts have occurred during the S&P 500's incredible increase. Although it has decreased, inflation is still beyond the Fed's target.
Concerns have been raised that we may be in a tech stock bubble similar to the dot-com bubble at the turn of the century due to the enormous rally, which has been mostly driven by excitement about artificial intelligence and a few large tech stocks.
Conversely, Nvidia is making a very impressive rate of growth in its revenue and profits, which are real. The most recent in a string of spectacular quarters, last week's results are "Unprecedented." And it illustrates the strength and tenacity of this artificial intelligence frenzy, says Dave Rosenberg, president of Rosenberg Research. The statement read, "Nvidia's outstanding performance and encouraging leadership drove home the point that generative AI is proving to be transformative in every way, and in ways most of us still can't comprehend."
Although the company won't maintain its near-monopoly position indefinitely, Rosenberg points out that it is currently well ahead and that, considering the company's rapid development, its share price doesn't seem all that high. According to Rosenberg, not many businesses of its scale have been able to sustain such growth, but if AI bulls are correct, it may be able to keep beating the odds. "The Magnificent One is essentially in the lead; the company is definitely in a class by itself."
The restricted scope of the gain, according to Deutsche's Allen, could be a vulnerability for the index. The market valuations of corporations determine the weighting of the S&P 500, which increased by 24.2% last year but would have increased by only 11.6% on an equal-weighted basis. This made 2023 the first year the S&P 500 outperformed its equal-weighted counterpart by more than 10 percentage points since 1998 (during the dot-com boom). The index has increased 6.7% year to date, whereas the equal-weighted index has only increased by 2.5%.
Furthermore, even though Nvidia's value may be simple to understand, the S&P 500 appears expensive overall: Because of the decline in full-year earnings per share projections for the index from $245 to $250 in October to $243 today, it is currently trading at over 22 times ahead earnings.
Essaye notes that a P/E ratio of that magnitude was "previously only reserved for periods of quantitative tightening and 5.37% fed funds, not quantitative easing and 0% rates."
Additionally, there is a chance that public opinion will turn against AI and demand more regulation.
"We will likely see high-profile generative AI failures in 2024," predicts Fred Havemeyer, head of Macquarie's US AI & Software Research, "particularly as AI earns more of the public's attention throughout the election cycle."
Naturally, doubters haven't yet proven to be correct. FactSet's average year-end price forecast for the S&P 500 is 5,556, which suggests that there is still over 9% of upside left in the year. Additionally, RBC Capital Markets has stated that the index appears to be able to sustain a value of 23.55 times.
Before gains hold, there's also a chance for a short-term decline.
It's difficult to determine if the AI boom is really peaking. However, it's important to keep in mind that ChatGPT is not yet an answer-all.
