We just completed the first week of December and the US equity markets, as measured by the S&P 500, have once again logged an all-time high week. On the surface this is a great number, but under the hood it was not so great. 7 of the 11 sectors in the S&P were down for the week. This is not the kind of broad strength that I would prefer. It doesn't make me go on defense, but it does make me cautious, particularly when Mark Newton of FundStrat says that this week and next, with the inflation data that will be released, could be tough weeks. Based on the current market readings, this bull cycle could last well into 2025. Internals like breadth, volume, investor sentiment and CEO business surveys are just a few of the studies we used when considering whether the “As Good As It Gets” moment is developing. We’ve found that the indicators we look at tend to begin to break down usually about 6-12 months before the cycle’s top. The turn in the indicators tend to lead the high point in the market. We expect internal deterioration to occur over a multiple-month period ahead of the S&P’s final peak. Generally speaking, the As Good As It Gets moment is when internal breadth is broadest and even poor selection has been rewarded.
Currently traders and investors of bullish persuasion (of which we are part) point to fundamentals that suggest the current resilience of the economy and the stock market appear poised to continue into next year while bears, skeptics, and nervous investors express concern of pending retracement risk sourced in views based on prior market history or market technical factors that could turn some near weakness on a data point or corporate guidance into a period of repricing to the downside. Based on several factors including US monetary policy, the resilience in economic growth, business activity, the consumer, and job creation evidenced in recent years and the current year, many company research teams have instituted price targets for the S&P 500 by year-end 2025 of 7000-7200. That is another 15-20% advance from this year and last’s substantial runs.
Beyond fundamentals that suggest to us further upside for equities from current levels there is increased appetite across all demographic groups for equities. This suggests to us an emphasis among investors on traditional “needs based” investing wherein the objective or goal is centered around the need to meet monthly financial responsibilities and to provide for things such as: growth of retirement assets for both income and asset growth; to provide a standard of living in what might be a longer retirement period than previous generations enjoyed; providing for a child’s education; investing for family legacy.
History suggests that stocks can be a resource for building assets, over intermediate and long time periods. The broadening of the market from the market lows on October 27, 2023, along with ongoing rebalancing suggest to us that the current bull market likely has legs strong enough to climb the proverbial “wall of worry” into and through 2025. The quality of economic, business, consumer and job growth data from the start of the Fed’s rate hike cycle in March of 2022 through the initial cuts to its benchmark interest rate in September and November (and likely again this month of December) suggests further underlying support for the economy to sustain the current bull market.
Beyond fundamentals artificial intelligence (AI) presents in our view a watershed point on the historic timeline of technology and economic progress that may parallel the automobile’s contribution to the economy from the 1920’s. That period of progress deeply changed the way, where, and how people lived. Over the course of the last forty years (and at an accelerated pace in the last 20- and 10-year periods) we have seen a broad array of technology become deeply embedded in the processes of business, the lives of consumers, in medicine, in education, and in government. In the period that lies ahead we look for AI to provide improved efficiencies for these groups. In the equity markets companies in all eleven sectors could benefit from improved productivity via AI to further serve the needs of business and customers. We’re not suggesting paradise on earth nor are we expecting a “Goldilocks world” but rather a genuine potential for AI to provide greater efficiencies in key areas that are challenging progress today across the sectors and society. The potential for better virtual shovels and virtual drill bits to mine a world of increasing mountains of data to find solutions at a quicker pace could be one of its greatest contributions.
Macro sentiment still not showing close to top
One of my beliefs, almost by definition, is that “the top is the point of maximum optimism.” There has been a lot of investor optimism this year, but I felt it was not “maximum” optimism because several measures of macro sentiment (social mood) still showed a lot of healthy skepticism. At major and secular peaks in stocks, nearly everyone is optimistic and in stocks. Even margin debt growth, has only risen some 14.9% over the last 15 months and it is usually up around 50% at major peaks. Of course, there are lots of ways to speculate these days, but still, I would have expected more margin debt at a major peak. In conclusion, macro sentiment is clearly rising, but I don’t see huge risks yet.
Along with a new all-time high for the S&P 500 last Friday, notable action last week included the high-beta (HB) vs. low-volatility (LV) ratio’s ability to reclaim its 200-day average for the first time since July. High-Beta is a group of more growth-oriented companies, whereas Low-Volatility tends to be slower growth and stable types of companies. In our current market, growth strategies have prevailed over value strategies, so this analysis clearly reflects this. We see HB outperformance as the “right” leadership consistent with higher highs into 2025 given that the underlying fundamentals are continuing and hence so should the types of companies that benefit from these economic benefits.
In the chart below, I have overlayed the S&P 500 above the comparison of High-Beta to Low-Volatility. Please focus on the most recent period (circled in yellow). In July of this year the rip-roaring Mag-7 (large technology companies) stopped their ascent, and other slower moving companies began to play catch up. When this happens, the boo-birds come out and say, “now it’s over for big cap tech.” What is more appropriate is to give the action a bit of time to mature to see if the action is one of the lower volatility companies playing catch-up or is it the high-beta companies playing catch-down. As can be seen in the chart below, it is now appearing that the action was the lower volatility playing catch-up and now that the High-Beta still has the positive fundamentals they need, they have now begun to reassert themselves. I can’t stress the importance of making comparisons like this. Often the action on the surface does little to explain what is going on under the hood. Also, one must be nimble and look at the factors that drive a move instead of simply being overly reactive.
I can’t stress the importance of making comparisons like this. Often the action on the surface does little to explain what is going on under the hood. Also, one must be nimble and look at the factors that drive a move instead of simply being overly reactive. In looking at the price movement of the High-Beta ETF and the movement of the Low-Volatility ETF, it is clear that they are both on the rise, but it is almost impossible to see how High-Beta got tired, and Low-Volatility got strong and then they switched.
Since every time things are different, I like to see what “thing” is taking the limelight and seems to be the driver in the current action of the markets. This time I think that Bitcoin can be considered today’s thing. In Friday’s Wall Street Journal, in the Review & Outlook section there was a very insightful commentary titled, “The Bitcoin Boom and Easy Money.” The article makes the point that if financial conditions are as restrictive as many would like us to believe and the Fed claims, the financial markets haven’t gotten the message. It appears that bitcoin, excess liquidity, foreign capital flows and the equity markets are reflecting the opposite.
Many are chalking up the bitcoin rally happening because Trump is crypto-friendly. There is no doubt that he is not pushing back on crypto, but instead trying to understand how the domestic economy could benefit from it, but it seems to have morphed into something bigger. One major reason is that general investors who were scared by the wild-west nature of crypto buying are now able to easily buy numerous ETFs now being approved. Another point is that many are now stating that just as gold is used as an alt-currency when the dollar is unstable, the same is being said about crypto. In any case, the move is real, and many benefited. Will it continue? With crypto being as misunderstood as it is, these next chapters are yet to be written.
In Saturday’s Journal an even better article was presented, “Is the Stock Market Doomed? Yes, But Maybe Not in 2025.” James Mackintosh was far more expansive in his explanation. He says that it is a widely known fact that based on history, equities are wildly overvalued, but that history shows no link between high valuations and the following year’s returns. And none of the analysis historically has any reference to understanding the impact of AI on earnings and labor.
Loudest voices
Over the long run, markets trade off fundamentals. Over the short run, they can feel like holiday office parties. The loudest voices garner the most attention, whether they are warranted or not. For the last several weeks, three topics have dominated the financial news cycle. By far the most common has been the U.S. election. We addressed it several times, with the bottom line being that the prospect for market friendly policies should give an already strong market another boost, at least through yearend. Areas of concern include the immeasurable impact of perceived Trump 2.0 tariffs and deportations could complicate the Fed’s job. The second topic has been whether the market has priced in much of the good news. We found that strong momentum and bullish optimism in November tend to be bullish through year-end (as we have been stating with statistical data for the past number of months), but like the political risks mentioned above, they could become problematic in 2025. The bottom line is that the weight of the evidence continues to lean bullish for U.S. stocks, both on an absolute basis and relative to bonds and cash. The last point is the ultimate voice of the cryptocurrency markets and how much attention they will demand as Tariff drums keep beating and immigration fears affect labor.
By its sheer size and relatively limited dependence on exports for growth, the US economy would be less impacted by tariffs than Canada and Mexico would be. US exports to its neighbors represent just over 2% of GDP, while the exports of Canada and Mexico to the US account for more than 20% of their respective GDP. Also, given Trump's style, his strong comments about the intent to which he could use the tariffs could be a sort of saber rattling to get the attention of foreign leaders and make them need to sit down and have some difficult conversations to avoid the disruptions of the tariffs. In looking at result of such large tariffs that are being considered, the impact on our economy could be detrimental and as a result have a negative impact on the business sector. I would doubt that Trump would implement tariffs at a level that damage the progress of our domestic labor force and economy.
In closing, we are at peak equity allocation in portfolios. But given the alternatives of cash, bonds and foreign equities, we still feel we are in the best house in a fickle neighborhood. As the inflation data of CPI and PPI hit this week and Fed Chairman Powell makes a decision on interest rates next week, the stage will be set for the year end. I certainly hope that Santa doesn’t drop coal down the market’s chimney, but instead sings show tunes for a positive 2025.
- Ken South, Newport Beach Financial Advisor
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