Stock markets continued rising in the second quarter, notwithstanding mounting concerns about inflation and dwindling hopes for a series of interest rate cuts before year-end. The US stock market has experienced over 30 new all-time highs this year.
However, beneath the surface, there are concerns that the narrow range of expensive AI stocks propelling the market higher has led to an unbalanced market at risk of a correction in the second half of the year.
Central bankers remained hawkish in the second quarter after inflation proved far stickier than expected in the first. Some headway was gained in the fight against inflation between April and June. However, risks remain to the upside, particularly concerning the geopolitical landscape, and thus, patience remains the watchword for the US Federal Reserve.
Though still cautious, other central banks felt there was sufficient space to reduce interest rates, and the Bank of Canada, Swiss National Bank, Sweden’s Riksbank, and the European Central Bank announced their first interest rate cuts.
The Bank of Canada reduced its policy rate in early June becoming the first of the G7 central banks to do so. Latest consumer price inflation figures raise the risk that the bank may have been premature. The headline and core inflation rates came in higher than expected in May, rising to 2.9% and 1.8%, respectively. Both price gauges experienced a 0.6% month-on-month increase, suggesting the system still has inflationary pressures.
The ECB’s decision to reduce its official rate ahead of the Fed at its June meeting was historic because it was the first time it had done so before the Fed. Some questioned whether it was a well-founded decision, given that the ECB President still sees risks ahead. ECB President Christine Lagarde noted that future decisions would remain data-dependent and said: “Despite the progress over recent quarters, domestic price pressures remain strong as wage growth is elevated, and inflation is likely to stay above target well into next year.”
The Fed’s main challenges to easing monetary policy include a still robust economy and a tight labour market. Some indicators have suggested a softening in the economy, including a lower-than-expected US GDP figure and The May ISM Manufacturing Purchasing Manager’s Index contracting for the second month in a row—recording a figure below 50—after expanding in March. The unemployment rate has also drifted slightly higher, and there are concerns that once unemployment increases, it does so quickly.
However, some other labour market indicators point to a still-tight labour market. Job creation remains above-trend, rising 4% in May, and according to ICIS, a still-healthy labour market is holding up consumers’ income and supporting the US economy.
Ideally, investors would like to see labour market supply and demand move back into balance, and the April JOLTS survey suggests this may be in the early stages of happening. The ratio of job openings to job seekers has declined over the past two years, with 1.2 job openings available for every job seeker in April, after US job openings fell by 296,000 to 8.1 million. That compares with 2 job openings for every job seeker in 2022.
In Europe, labour markets are still tight, and wages are rising at an elevated pace. Pressure on wages is expected to remain relatively high in the face of demographic shifts, namely an ageing population, and due to deglobalisation, which means goods will no longer be manufactured in the most cost-effective locations.
Canada’s tight labour market is loosening, according to Bank of Canada Governor Tiff Macklem, who says it is closer to being in balance. He expects the unemployment rate, at 6.2% in May, to rise further in response to the Bank’s efforts to get inflation back to its 2% inflation target. However, he says a large increase is not likely and is confident that Canada’s economy is heading for a soft landing.
Against this mixed economic backdrop, with expectations regarding the extent of rate cuts this year now dramatically lower, financial markets have continued to outperform expectations. Though expectations for six rate cuts have now dwindled to one, perhaps two, the US S&P 500 Index has continued to achieve new record highs and is 15% higher at the halfway mark of 2024.
However, there are concerns that the bull run is becoming increasingly imbalanced because it is still relying so heavily on the outperformance of the Magnificent Seven AI-mega stocks—and Nvidia in particular. The chip maker accounted for some 33% of the S&P 500’s June rally. Meanwhile, the top-heavy nature of the stock market run is evident in the 17% decline in the Russell 2000 index of smaller companies from its November 2021 peak and its sideways move this year.
Even taking a wider view, the S&P 500’s rise is the result of 198 stocks that have made gains this month, less than 40% of the index. According to the Wall Street Journal, the average stock has not moved since the start of 2022, and half of the universe of stocks has lost ground since then.
As a result, analysts and surveys reflect emerging pessimism around what can be expected from Wall Street in the forthcoming year. Investors are increasingly nervous about the stock market’s elevated valuations according to Bloomberg’s latest Markets Live Pulse survey.
Half of the respondents in the survey expect the stock market to correct by at least 10% this year, and 35% expect this next year. However, they do still expect modest gains for the year as a whole, with the survey’s median projection 5,606 by the end of the year, around 2.5% higher than late June levels.
JP Morgan is one of the most pessimistic investment houses. It expects the US stock market to decline in the months ahead and recommends investors maintain an underweight position in stocks.
JPMorgan’s chief market strategist and co-head of global research, Marko Kolanovic, notes that equities are pricing in little downside risk despite many risk factors in play, including political and geopolitical issues, narrow market concentration, a surge in meme stock and crypto trading, still elevated inflation rates, and signals that there are still risks of an economic slowdown or recession.
Blackrock has a more tempered view, believing that solid earnings could result in a greater dispersion of investment opportunities beyond AI beneficiaries. In its third-quarter outlook, it says: “We see the earnings-growth gap between these leaders and the rest closing later this year. This presents a compelling opportunity for stock selection, as earnings feed valuations.”
The investment manager notes that the “Magnificent 7” mega-caps were priced at roughly 34x earnings in late May, while the other 493 stocks in the S&P 500 traded at a “much less demanding” 17x. It adds that the top stocks still have a strong earnings profile and thus are not necessarily expensive relative to their growth prospects.
Later in the quarter, however, there were signs of over-exuberance emerging, with meme stocks and cryptocurrencies regaining attention.
In early June, it became known that Keith Gill, the central character in the 2021 meme bubble bursting, had again built up a significant stake in GameStop, which saw shares rally 21% to $28. The last time meme stocks were caught up in a speculative frenzy, investors paid significantly for the diversion between what the companies were really worth and what the investors were willing to pay for them. Still, it appears there is excitement in the markets, with stocks being bought on margin, indicating that retail investors remain bullish. The amount of margin debt at the end of May 2024 stood at USD $809.431 billion.
According to GuruFocus, the Shiller PE Ratio for the S&P 500 stood at 35.37 as of June 1, 2024. Historically, this ratio reached a peak of 44.2 during the Dot-Com bubble in 1999, with the lowest recorded value being 4.78 and a median of 15.95. Typically, the ratio has ranged between 26.5 and 33.4. Currently, it is above this typical range and is approaching the highs seen in late 2021, a period marked by rampant speculation during the pandemic market frenzy.
The cryptocurrency market benefited from the US Securities and Exchange Commission’s May decision to allow the creation of spot Ethereum exchange-traded funds. However, speculative fervour appears muted for now, with Bitcoin prices recovering in May but falling back again in June.
At present, the economic picture continues to look mixed, with no real signs of a recession or hard landing ahead. However, growth shows some weakness in the US, and interest rates are only likely to come down when there are convincing signs of inflation sustainably easing, for instance, at least three positive figures consecutively. Stock markets remain on a tear, but with a fraction of the share universe underpinning the rally and the lack of breadth and elevated valuations worrying many analysts. When meme stocks come back into the spotlight, it’s always a sign that speculative appetite is returning, but fortunately, cryptocurrencies are not showing subject to the same unfounded investor views.
For investors who are navigating this high valuation environment, its preferable to stay invested with quality companies that have been acquired at reasonable valuations and trim exposures that have become too rich due to market enthusiasm.
Garnet O. Powell, MBA, CFA is the President & CEO of Allvista Investment Management Inc., a firm with a dedicated team of investment professionals that manage investment portfolios on behalf of individuals, corporations, and trusts to help them reach their investment goals. He has more than 25 years of experience in the financial markets and investing. He is also the Editor-in-Chief of the Canadian Wealth Advisors Network (CWAN) magazine. He can be reached at gpowell@allvista.ca