Overview– The rally in the equity market has built momentum during the third quarter. When we penned our second quarter outlook, the market had barely broken out above the highs of 2024, but the market has now extended about 10% above last year’s high. While the labor market is showing signs of weakening (this may be mostly due to reduced immigration), the US economy continues to muddle along in a “K” economy where the top wage earners are doing much better than the rest of the population.
The most substantial change since our last outlook is Fed Policy. Having cut rates once in September, and again this week, with another cut possible later this year, the Fed is clearly in an easing mode. This is typically bullish unless the economy is in the middle of a recession – which is not the case at the moment. J.P. Morgan research highlighted that there have only been four instances in which rates were lowered with the S&P 500 at an all-time high. One year out, the benchmark was higher each time with an average return of 20%; the worst return was 15%. Of course, there are no guarantees, but with the monetary winds to its back, the markets can continue to move higher unless an economic shock occurs from a policy change (we have already seen this once this year, so it is not out of the question). The seasonal tendency is for stocks to do well in November and December, providing an even stronger case for strength in the short term. However, gains will be tempting to take at the beginning of next year as it delays capital gains for a year.
Longer term, valuations are at levels associated with secular peaks in the equity markets. Valuations are never a good timing factor for the stock market; however, it is generally a warning of potential future lower returns in the coming years. Debt to GDP is at an all-time high, only challenged by the post WWII high. The current administration appears to be trying to grow their way out of this historic debt situation while striving to keep rates as low as possible. They are attempting to achieve this by easing austerity and fiscal responsibility. This has the effect of boosting asset prices, at the expense of a depreciating currency. This helps explain why precious metals and stocks are doing well. A continuation of this policy would keep valuations high at the expense of a lower dollar and potential inflation. Watching inflation will be key in recognizing stagflationary signals which would be good for commodities but likely negative for stocks and bonds.
Rates are drifting lower at the short end of the yield curve, but surprisingly also in the long end, even as inflation stays steady at 3%. This may indicate the bond market anticipates a weaker economy and that more Fed eases are coming. At some point, if the economy weakens too much this would be an obvious concern. We do not see this now as earnings are strong, but at these historically high valuations, it bears watching the bond market carefully.
Market Discussion– It cannot be emphasized enough how concentrated and undiversified the stock market is as defined by the S&P 500. The Technology sector now comprises 43.6% of the S&P 500 Index – which is an all-time high (However, this sector does not include obvious technology names like Google, Amazon, Tesla, and Meta which are not officially categorized as part of the Technology sector but are all either Hyperscalers or battling to win the AI war). Further, many times this year, the top 5 stocks in the S&P 500 made up more than 30% of the index and single company allocations amount to between 5% and 8% of the index.
This is to demonstrate that it is not hyperbole to say that the S&P 500 is no longer a diversified index. In such an environment, you had to have even more than those already excessive concentrations in the Technology sector and individual weightings to outperform, which amounts to adopting an even riskier investment posture! Warren Buffet is famous for saying “be fearful when others are greedy and be greedy when others are fearful.” This strategy has failed this year – a rare occurrence indeed. The only strategy that has paid off this year is to be greedy while caution has been thrown to the wind!
It is likely that there are two different potential outcomes from the current predicament: the market tops in a manner like the dot com bubble, or the rally broadens out as strength is passed down to other areas of the market. The equal-weight S&P has continued to lag severely over the past month, as it has since the market bottom in 2022. But in fairness, there are signs that such a broadening is occurring, and we need to see this to continue to feel comfortable with current market dynamics.
Trading Discussion– We have held onto our bullish posture with a beta higher than the market. We favor areas that will benefit from the large investment in AI infrastructure rather than in the Mag 7 names directly (we do own three of these). AI related infrastructure names are not nearly as expensive as many companies with extremely large weightings in the index. Further, we are invested in a more diversified and less concentrated manner than the indices. We also have an important allocation to international stocks, which have and should continue to benefit from a weaker dollar. We are holding on to our small and mid-cap allocation as lower interest rates typically benefit this asset class. We are not comfortable being overweight in small and mid-cap names as any economic weakness – a risk we are watching – is especially detrimental to this asset class. We are also holding onto our commodity sector investments such as gold, goldminers, uranium and other related commodity ideas, as a weakening dollar should continue the strong trend this year. Gold is currently in a short-term pullback from one of the strongest uptrends in decades, but we doubt it has topped.
Outlook– We continue to feel that while earnings momentum improves and analyst revisions move higher – both are occurring so far in the 3Q earnings reporting season – the market can move higher even in a slowing economy. Sentiment is still not as bullish as we would expect if the market were peaking, so the path of least resistance is likely higher. Valuations are at a level that can only be described as very expensive, like previous secular peaks, but this means little in the short term. Valuation measures are never a good short term timing indicator. However, valuations are excellent measures of long-term forward expectations because starting valuations are the most important indicator for future long-term returns. This is a reminder that being an active manager and willing to take risk off the table when the situation changes is of paramount importance in the current market.
