Research.LeutholdGroup

Whether or not the label "bubble" fits this market, U.S. economic risks continue to rise, while Mega Cap valuations home-in on levels seen only in 1999 and early 2000.

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The stock market looks (superficially?) better in late summer than it did at its “old” high on February 19th. It’s far from cheap, but is no more expensive than in February, and technically speaking, the S&P 500’s July’s highs were broader than those of February. That said, there’s divergent action among secondary measures that are troubling.

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As a testament to the severity of the 2000-2002 Tech Wreck, performance of recent years’ laggards, like the Equal-Weighted S&P 500, S&P MidCap 400, and S&P SmallCap 600 are still well ahead of large-cap Growth on a 25-year basis.

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Nine of ten components in the LEI are signaling there’s trouble dead ahead. Yet, the 12-month momentum of the sole outlier, the S&P 500, still looks sufficient to forestall an imminent slide into recession. Additionally, the index’s short-term strength also supports the argument that SPX is “too strong.”

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Given the prevailing conditions at the beginning of this bull market, the S&P 500 has been an overachiever, though the same can’t be said of the broader market. This translates to an opportunity for active equity managers that nearly matches conditions in Y2K—and at a time when the active manager pool is now dwindling.

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The market lacks the traditional bubble feel because investor giddiness is simply not shared by consumers—which is markedly different that of the late 1990s. There is a huge disparity between confidence about stock price gains vs. expectations for consumers’ near-term economic well being—a gap that did not exist during the Tech Bubble.

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The LEI’s recession warning in June 2022 was woefully premature and has persisted for so long that it’s now met with eye-rolls. Nonetheless, economic momentum—specifically the lack there of—is why it may be time to take that ominous signal seriously.

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The U.S. economy is now mired in what we view as a temporary phase of stagflation. To our way of thinking, the “flation” is, in fact, exacerbating the “stag”—a situation that should soon self-correct in an unpleasant manner.

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The Cyclical/Defensive Relative Valuation Ratio jumped to yet another record in July, with Cyclicals commanding a valuation premium of 23%. Put differently, investors have a very strong implicit bet that the economic expansion will continue.

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Though it’s ramping up daily, the level of retail participation in the stock market is not quite on par with that observed during the last gasp of the Technology Bubble. Maybe a phase of full-blown euphoria still lies ahead. 

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With the S&P 500 snapping back to new highs, our team revisits the bubble debate. While valuations flash warning signs, speculation and momentum tell a more measured story.

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The market correction into the lows of early April was very painful, with the S&P 500 doing its usual job of camouflaging deeper declines in measures like the S&P MidCap 400 (-24.5%), S&P SmallCap 600 (-28.4%), and an index that’s become our poster-child for the frustrations of active managers—the Equal Weighted S&P 1500 Composite (-24.0%). 

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Bulls have more to cheer than the latest string of new highs. Another recession signal was issued in May by the Conference Board’s Index of LEI. Why cheer? In this decade, LEI has proven a superb contrary guide for stocks: Since 2020, LEI has been in recession mode 45% of the time, and SPX delivered +18% annualized during those months.

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We’ve had some internal debates as to whether the U.S. stock market qualifies as a bubble. Our tentative answer is “not yet.” Among the reasons: Speculative enthusiasm is not yet at truly manic levels, and the market’s 1-year advance is extremely muted vs. terminal blow-off phases in prior asset bubbles.  

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Since 1990, a monthly rebalanced, equally-weighted portfolio of the 50 stocks with the highest Price/Sales ratios has trailed both the cap-weighted and equal-weighted versions of the S&P 500 by about 3.0-3.5% per year on a total return basis. 

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Housing activity remains at very depressed levels, with 30-year mortgage rates near 7% keeping those with low-rate mortgages frozen in place, and those wishing to get into a home are frozen out. Qualifying income to buy a median-priced home is almost $105,000—up 122% from Feb-2020.

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Our S&P 500 Cyclical Sector Composite is one of three market bellwethers to join SPX at an all-time high. While technically bullish, the action generated a concurrent new peak in relative valuation that should temper the optimism of those heavily invested in traditional cyclical sectors. 

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SPX has become less representative of the broader U.S. stock market both in performance and valuation. In fact, the S&P 1500’s normalized P/E ratio has slipped below its long-term median, implying that returns near the long-term norm of +10% could be possible for the average stock in that index. 

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The SPX upturn to a new high has been confirmed by just three of the eight bellwethers we use to monitor breadth and leadership. Yet, we don’t view the uneven recoveries by the other eight as abnormal; our instincts are to wait a bit longer before classifying the laggards as yellow flags.

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“Sell In May” has been better advice historically than random chance suggests. Still, that seasonal pattern has so far been “Trumped” this year, with SPX +12% since late-Apr. Technicians tend to view new market highs as bullish, but that’s not always the case. The NYSE Daily A/D Line provides a clue as to whether the mid-year strength is apt to persist.

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