We’re in a roaring bull … but recognize where we are in the broader cycle … indicators suggesting longer-term pain … but take advantage while you can

As I write Wednesday morning, semiconductor stocks are selling off sharply.

This comes after news that the Biden administration is considering a wide-sweeping rule to limit companies exporting their chipmaking equipment to China.

However, many small-cap stocks and non-tech Dow Jones stocks are still climbing as I write.

Stepping back for a bird’s eye view, though we’re seeing a rotation of money away from tech stocks toward small-cap stocks, this remains a roaring bull market.

At the same time, the risks associated with this roaring bull market are increasing.

In this Digest, let’s take stock of where we are in this broader investment cycle. The bottom line is that we want to take advantage of what’s here today but be aware of what’s lurking on the horizon tomorrow.

One week ago today, the S&P 500 notched its 37th all-time high of the year

We’re in rare air up here.

To illustrate, below, we look at data from Charlie Bilello at Creative Planning. The blue cells represent years in which the S&P made all-time highs, showing the respective number of all-time highs.

At 37 – and barely halfway through the year – we’re on pace to rival the highest number of all-time-highs set in any year dating back to the 1920s. The current record goes to 1995, which notched 77 different all-time highs.

Now, as we’ve detailed extensively in the Digest, this rally in the first half of the year was remarkably narrow, concentrated in a handful of Big Tech/AI stocks. However, after the last week’s cool CPI report, money is flooding into new corners of the market.

Let’s go to our hypergrowth expert Luke Lango for more on this. From Luke’s Daily Notes in Innovation Investor:

We’re very confident that an “Everything Rally” across the stock market began last week and will only strengthen in the coming weeks and months, creating some tremendous buying opportunities.

As you know, the Everything Rally started because the June inflation report was very soft and showed that the inflation rate actually dropped to 3%, meaningfully hiking odds of the Fed’s first rate cut by September and energizing investor hopes for a “soft landing” out of the U.S. economy.

The Everything Rally further strengthened [on Monday] on the back of dovish comments from Fed Chair Jerome Powell, who confirmed in remarks what the market already suspected – that last week’s inflation report was soft enough to all but guarantee a first cut by September.

Luke also points toward the increased likelihood of a Trump second term, which Wall Street views as more business-favorable than a Biden second term. Additionally, analysts are anticipating a strong Q2 earnings season.

All of this is coming together as a powerful tailwind driving just about everything higher (except for mega-cap tech, which Luke believes will soon stabilize).

Here’s his forecast for the next handful of months:

Small caps should outperform. But large caps will prove more stable. AI will remain the “hot ticket”. Both AI builders and appliers will rally. But appliers should outperform.

Rate-sensitive stocks – like consumer discretionary stocks, travel stocks, biotech stocks, real estate stocks, and crypto stocks – should all do quite well.

This type of “everything” rally is rare, so when we’re fortunate enough to find ourselves in the middle of one, we want to take advantage – but – we must do so wisely.

Let’s talk about why…

The warning sign embedded in the “all-time-high” data table from above

A moment ago, we presented the table of all-time highs from Charlie Bilello. Let’s look at it again, but from a different perspective.

This time, notice what follows multi-year stretches of blue cells (meaning years filled with all-time highs). You’re going to see it’s often a vast expanse of white cells filled with “0.”

Long stretches of outperformance give way to long periods of underperformance. This is the normal ebb and flow of the stock market.

So, as you look at the chart above, what’s more likely based on the sea of blue cells we’ve enjoyed since 2013 – another decade of blue cells? Or perhaps a stretch of white “0” cells?

Of course, my question (and its implication) isn’t rooted in anything other than pure speculation. Is there an actual indicator suggesting caution?

Yes. Several of them.

Beware of “the most reliable predictor of stock returns over a ten-year horizon”

Last week in the Digest, we highlighted research from Stéphane Renevier from Finimize:

A lot of things can influence short-term stock returns: interest rates, economic data, geopolitical stuff, investor sentiment – even weather.

But for long-term returns, one factor rules them all: the proportion of assets that investors are parking in stocks.

This ratio has proven to be the most reliable predictor of stock returns over a ten-year horizon, outshining even heavyweight factors like valuations.

It says that when investors go big on stocks, their long-term returns tend to be below average…

Investor over-allocation to stocks has been the most precise warning signal of lost decades. A spike in allocations to stocks (blue line, red shaded circles) preceded both the lost decade of the 1970s and the early 2000s. 

You might have trouble seeing the chart above due to sizing, but if you can zoom in, you’ll notice that the most recent peak in stock allocation came around 2020/2021 (which suggests trouble for the next decade), and the chart hasn’t been updated to today.

Has the number of Americans owning stocks fallen, perhaps taking pressure off this indicator?

No. According to the Fed’s Survey of Consumer Finances, an all-time high 58% of American households owned stocks last year.

This is troubling. Bull markets stop charging when everyone already owns stocks and there’s no one new to buy.

With U.S. stock ownership at an all-time high, are we more or less likely to enjoy another long stretch of monster market performance?

There are also warnings signs from today’s market valuation

“CAPE” stands for “cyclically adjust price-to-earnings” ratio. It’s a long-term measure of a market’s valuation. It’s the traditional price-to-earnings ratio of a stock but it uses rolling 10-year average earnings to smooth out business cycle fluctuations.

The CAPE ratio isn’t a market timing tool. But it does offer investors a helpful and remarkably accurate expectation of long-term forward returns.

Markets tend to mean revert over time, so a stock or index that has a high CAPE value today is more likely than not to see its value fall in the coming years. That would mean below-average stock returns should be expected.

On the flip side, a stock or index that has a low CAPE value today is more likely than not to see its value rise in coming years. And we should expect above-average returns.

The more extreme the starting CAPE value (either high or low), the more pronounced those ensuing 10-year returns often are.

Below is a chart from my friend and quant investor Meb Faber, CIO of Cambria Investments. Starting in 1900, the chart shows initial CAPE values of the S&P and what the ensuing 10-year returns were after beginning at the specified CAPE value.

Dark green represents the cheapest CAPE starting years (CAPEs between 5 and 10).

Red represents the most expensive (CAPEs between 20 and 45).

As you’ll see visually, most of the “green” starting years (low CAPE ratios) end up on the right side of the chart — meaning big 10-year returns.

On the flip side, “red” starting years (high CAPE ratios) usually end up on the left side of the chart — meaning low and negative 10-year returns.

So, what’s the S&P’s current CAPE value?

36.43 – the third highest level in 150 years, and deep into the “red” bucket of dangerous starting valuations.

We get greater insight into today’s richly valued stock market by breaking down recent gains into “fundamentals” versus “sentiment”

As we’ve detailed here in the Digest, a stock price comes from two variables: earnings, and the multiple that investors are willing to pay for those earnings (think “sentiment”).

With this in mind, let’s return to Bilello from Creative Planning:

The past 10 years have been great for the stock market with the S&P 500 index increasing 188%.

Have the underlying fundamentals shown similar gains?

Not exactly. S&P 500 Sales have increased 58% over that time while Earnings are 95% higher.

Which means that stocks are higher not just because of fundamental growth but also because of multiple expansion.

Translation – bullish investor sentiment has been a huge contributor to the last decade of returns. This has pushed valuations to nosebleed levels that fundamentals alone don’t justify.

But let me show you one example so you can see for yourself.

Below, you’ll see the S&P’s price-to-sales ratio now clocks in at 3. Is that a lot?

Yes – it’s double the historical median reading.

Here again – is it more likely the stocks keep climbing and we go to, say, 4X sales? Or do the odds favor mean reversion and a lower price-to-sales ratio?

If you’re starting to get nervous and considering liquidating and hiding out in a 5% high-yield savings account, hold on

Let’s remember the wise words of legendary hedge fund manager Peter Lynch:

Far more money has been lost by investors preparing for corrections, or trying to anticipate corrections, than has been lost in corrections themselves.

We want to stay in this market while it’s making us money. And we want to maintain humility about any undercurrent of bearishness we might have.

I regularly read insights from an incredibly bright analyst. I agree with much of his cautious outlook. However, this analyst has attempted many short trades over the last year (bets that profit if a stock or market falls). The vast majority of these short trades have lost money.

It’s a good reminder that even if your analysis is correct in the broad sense, if the market doesn’t agree with your timing, you can lose a boatload of money.

So, what’s our action step then?

Regular Digest readers already know the answer.

Mind your stop-losses… use wise position sizes… maintain a balanced portfolio of various assets that are non-correlated… and then stay in the market for as long as the bullishness is here.

I’ll add two extra suggestions before we sign off

First, it’s likely that a handful of your positions have become excessively large over the last year. For example, borrowing from this morning’s news, maybe your semiconductor ETF has exploded higher thanks to holdings such as Nvidia or Qualcomm.

Consider rebalancing.

In other words, take some partial profits, therein derisking your position. Either invest the proceeds in other positions you’re confident in or sit in 5% cash while waiting for the next fat pitch opportunity.

Second, consider “renting” the market instead of “owning” it. In other words, change your mental orientation to trading this market using shorter timeframes.

Legendary investor Louis Navellier is a proponent of this approach. Recently, he’s been taking advantage of what he calls “flash trends.”

These are sudden, sharp stock rallies that Louis’s quantitative algorithms identify. He stays with the trades until those same algos suggest the bullish move has run out of steam, then he takes profits and looks for the next flash trend stock.

We’ll bring you more on this over the coming days, but if you’d like to learn more now, click here.

Overall, though today’s selloff might be the start of an overdue breather, this market wants to run – so let’s run with it

But recognize that we’re running on increasingly thin ice. Eventually the weight of this bull will prove too heavy, and the ice will break. Be ready for when that happens.

But until then, enjoy the gains.

Have a good evening,

Jeff Remsburg