The Bottom Line:
- The market may be headed for a 5% or more decline before the year ends, based on historical patterns following strong first quarter returns.
- Valuations are looking pricey, with the S&P 500 trading at a 30% premium to its 20-year average PE and tech stocks trading at a multiple of 30.
- Big cap tech stocks continue to dominate returns, raising concerns about the market’s reliance on a single sector.
- Stock splits by high-profile companies may indicate management’s optimism about the future and serve as a psychological tailwind.
- Political uncertainty, both in Europe and the US, could impact the market, with the strategist drawing parallels to previous election years with third-party candidates.
Historical Patterns Suggest Impending Market Decline
Eleventh Best First Quarter Return Since World War II
While the market may be headed a bit higher in the near term, there are increasing concerns about a potential decline of 5% or more before the end of the year. Historical patterns suggest that out of the top 15 first quarter returns since World War II, 14 of them experienced declines of 5% or more. If the decline was less than 10%, there was a repeat, with the average decline being around 12.5%. However, the silver lining is that each of these 15 years posted full-year gains, with the average being above 20%.
Potential Triggers for a Market Pullback
The market tends to get tripped up by unanticipated events, which are hard to predict. If the market moves too quickly, with the S&P 500 trading one standard deviation above the average difference between its 200-day moving average and the index itself, it may be time for a resetting of the dials. Additionally, if economic indicators point to an economic slowdown, causing investors to worry about a potential recession rather than a soft landing, it could trigger a market pullback. However, these resettings of the dial are considered healthy for the market.
Valuations and Sector Performance
The market is currently looking pricey, with the S&P 500 trading at a 30% premium to its 20-year average PE. The technology sector is also trading at a multiple of 30, which appears to be a firm ceiling for the group. Attractively valued sectors from a relative PE discount perspective include midcaps, small caps, energy stocks, and utilities. Technology has been the best-performing group on a year-to-date basis and was the only outperforming sector in the past week. However, there are concerns about how long the market can continue to fly on only one engine, with technology dominating returns.
Overvalued Stocks Raise Concerns, Tech Sector Dominates
Overvalued Stocks Raise Concerns
The market is currently looking pricey, with the S&P 500 trading at a 30% premium to its 20-year average PE. The technology sector is also trading at a multiple of 30, which appears to be a firm ceiling for the group. This overvaluation raises concerns about the sustainability of the current market rally and the potential for a significant correction in the near future.
Tech Sector Dominates Market Returns
Technology has been the best-performing group on a year-to-date basis and was the only outperforming sector in the past week. The sector’s dominance in driving market returns has led to concerns about the market’s reliance on a single sector. Investors are questioning how long the market can continue to fly on only one engine, with technology stocks accounting for a significant portion of the gains in major averages.
Attractively Valued Sectors Offer Opportunities
Despite the overall market’s high valuations, some sectors remain attractively valued from a relative PE discount perspective. These sectors include midcaps, small caps, energy stocks, and utilities. Investors looking for potential opportunities in the current market environment may consider focusing on these sectors, which have not experienced the same level of overvaluation as the technology sector.
Big Tech’s Outsized Influence on Market Returns
Big Tech’s Disproportionate Influence on Market Performance
The technology sector has been the driving force behind the market’s strong performance, with big tech companies dominating returns and setting new records. Technology was the best-performing group on a year-to-date basis and the only outperforming sector in the past week, with gains of nearly 6% compared to the S&P 500’s less than 2% increase. This raises concerns about the market’s reliance on a single sector and the sustainability of the current rally.
Valuations Reaching Unsustainable Levels
The market’s valuation is becoming increasingly stretched, with the S&P 500 trading at a 30% premium to its 20-year average PE. The technology sector, in particular, is trading at a multiple of 30, which appears to be a firm ceiling for the group. This overvaluation raises questions about the potential for a significant correction in the near future, as the market may struggle to maintain its current trajectory without broader participation from other sectors.
Selective Approach to Utilities Sector
While some strategists have been bullish on the utilities sector, citing its potential to offer both offensive and defensive benefits, a more selective approach may be warranted. Only three of the 31 companies in the S&P 500 utilities sector index are significantly AI-related and posting above-average returns. Without these stocks, the sector would be underperforming. Investors considering the utilities sector should be mindful of this and focus on identifying the specific companies that are likely to benefit from increased power needs for data centers and other AI-related applications.
Stock Splits: A Sign of Management Optimism or False Hope?
Stock Splits as a Positive Signal
The recent announcements of stock splits by high-profile companies, such as Nvidia and Broadcom, may indicate a growing sense of optimism among company management about the future. By making their share prices more accessible to a greater number of investors, particularly retail investors who focus more on the price of the underlying stock, these companies are signaling confidence in their prospects. While institutional investors tend to focus on the dollar value of their investments, retail investors often find lower-priced stocks more appealing and affordable.
Psychological Tailwind for Companies
Although the practical implications of stock splits have diminished over time, with the advent of commission-free trading and fractional shares, they still serve as a psychological tailwind for companies. In the past, stocks would typically split when their prices reached between $40 and $80 per share, making them more appealing and affordable for investors. Today, while the financial barriers to investing have been greatly reduced, stock splits continue to send a positive message to the market about a company’s confidence in its future growth and performance.
Balancing Optimism with Caution
While stock splits can be seen as a sign of management’s optimism, investors should still approach the market with a degree of caution. The overall market valuation remains high, with the S&P 500 trading at a significant premium to its historical average. Additionally, the concentration of gains in a few key sectors, such as technology, raises concerns about the sustainability of the current rally. As always, investors should carefully consider their individual financial goals and risk tolerance when making investment decisions, rather than relying solely on the positive sentiment generated by stock splits.
Political Uncertainty in Europe and US May Impact Markets
Political Uncertainty in Europe and the US
The current political landscape in Europe and the United States is marked by uncertainty, with potential shifts towards the right in both regions. In Europe, recent events suggest a possible move to the right, while in the US, the upcoming presidential election has become increasingly complex with the entry of third-party candidate Robert Kennedy Jr. alongside the closely matched frontrunners, Donald Trump and Joe Biden.
Historical Parallels and Market Implications
The current political situation in the US bears similarities to previous election years, such as 1948, 1968, and 1980, when third-party candidates played a significant role in disrupting the traditional two-party dynamic. Historically, the market’s return from July 31 through October 31 served as a reliable indicator of the election outcome, with an upward move pointing to a reelection and a downward move suggesting a replacement. However, the presence of third-party candidates can act as disruptors, making the outcome less predictable.
Monitoring Congressional Bills and Polls
Market strategists and analysts are closely monitoring the political developments in Washington, keeping track of both the bills going through Congress and the polls indicating which candidates are leading the race. The Washington analysis arm of financial institutions plays a crucial role in assessing the potential impact of political outcomes on the markets. As of now, the prevailing view is that if the election were held today, Donald Trump would emerge victorious, signaling a further shift to the right in the United States.
