Research.LeutholdGroup

Early this month we trimmed net equity exposure to 50% across tactical allocation strategies. Breadth, leadership, and momentum into the SPX high on February 19th all showed divergences that could have been pulled from an “analyst’s handbook” of bull market tops.

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Given the prominence of the wealth effect in recent years, it’s hard to fathom the economy not succumbing to a declining stock market. But, keep the Y2K example in mind if the economy doesn’t appear to justify a falling stock market.

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Our composite of S&P Cyclical sectors topped more than three months ago. However, the action in this index looks even more ominous when compared to recession-resistant sectors like Consumer Staples, Health Care, and Utilities. 

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Flip-flopping about tariffs has damaged confidence and at a time when the economic expansion already looks fragile. Back in 2017 and 2018, Trump Tariffs 1.0 occurred with an economy much better positioned to absorb the tariffs themselves, as well as the confusion surrounding them.

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Federal receipts are projected to move higher in the months ahead, as capital gains taxes are collected. Lately, though, growth in tax receipts has fallen short of that forecast. After 16 years of a mostly rising stock market, we wonder if investors have been trained not to sell.

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A number of S&P 500 valuation measures are challenging the peak levels seen just before the Y2K Tech Bubble blow-up. Ironically, despite the stock market being vastly larger today relative to the economy (197% of GDP vs. 137% in February 2000), present day consumers are not nearly as euphoric as they were 25 years ago.

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For months, the euphemism to describe the weakening labor market has been “normalization.” Our preferred terminology has been “pre-recessionary,” and the numbers continue to trend in that direction.

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Only time will tell if the S&P 500’s February 19th high will turn out to be the ultimate top for this bull market. One dynamic for which we do have high conviction is that the tide has turned away from the large-cap growth crowd that has trounced all challengers since the market lows in October 2022.

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A sudden loss in investor confidence, like the recent plummet in the AAII Bull-Bear Spread, can occasionally become a self-fulfilling prophesy—and the current backdrop raises the odds that might be the case. Furthermore, consumers’ assessment of their Present Situation (Conference Board Survey) is now lower than at the October-2022 bear market bottom.

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Since the onset of the current bull market over two years ago, the S&P 500 Normalized P/E multiple has resided in its top historical quintile. That is an incredible feat—but one that has borrowed from the future.

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The median normalized P/E ratio for the S&P SmallCap 600 fell to 21.0x in February, the bottom quintile of all monthly observations since 1994. Historically, a normalized P/E multiple near the current level has been associated with a five-year-forward annualized return for small caps in the double digits.

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Discussion of Donald Trump’s policy antics could fill up this section for the next 47 months (… not that we’ve already begun to count them down). But there’s the problem of timing.

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When the S&P 500 made all-time highs the week of Thanksgiving and the following week, we viewed it as “risky, but not toppy.” Today, it is every bit as risky, but now looks toppy, too. There’s enough “wrong” with the picture that if the market immediately began to fall apart, the technical crowd would be able to cry, “It was obvious!”

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In two years, relative to the S&P 500 index, the median stock’s Price/Cash Flow ratio has swung from a 15% premium to a 19% discount. That’s only a point above our 10th-percentile undervaluation threshold. Prior breaches of that level always coincided with better times for active management—we expect this time will be no different.

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Large Cap U.S. stocks remain in a bubble phase, per the valuation thresholds we identified a year ago with a pencil and ruler. Yet, rapid growth in EPS—including our estimate for S&P 500 5-Yr. Normalized EPS—has held these measures below the extremes of the Y2K Tech bubble peaks and post-COVID mania.

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Unweighted valuation measures do not show a stock market that’s broadly overvalued. Thanks to market narrowness, it’s a stark contrast to 2021—a market we view as the most broadly overvalued of all time. It’s a good setup for active managers.

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Despite the steady decline in the Fed balance sheet under the continuing QT, “Net Fed Liquidity”—which adjusts the balance for reverse repurchase agreements (RRA) and the Treasury general account (TGA)—is actually unchanged since the fall of 2022. Not coincidentally, that’s when the current bull market began.

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The Index of Leading Economic Indicators has been out of sync for 2½ years. That dates back to the initial recession warning triggered in June 2022, a signal now deemed a failure. On an annual basis, the LEI has now logged two of its worst all-time forecasting misses in back-to-back years.

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Action in Homebuilding stocks tends to defy the popular caveat, “valuation is not a timing tool.” Readings above 2.0x book value coincided with all of the group’s major relative performance peaks; it would have been a good idea to lighten exposure when these stocks traded one tick above that level late last summer. 

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We believe stock market leadership will transition from Growth to Value in 2025. The P/E premium commanded by Growth stocks relative to Value is high, although not (yet?) quite as extreme as at the Y2K Technology bubble peak.

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