The S&P 500 Index’s recent significant rebound has historically signalled the end of bear markets and the onset of new bull markets, fostering optimism among investors. Several favourable factors contribute to this positive sentiment. The depreciation of the US dollar, coupled with better-than-expected US manufacturing numbers (PMI of 49 in July, surpassing the 46.7 estimate), reinforces the economic outlook.
Notably, consumer confidence and home prices have outperformed expectations this week. Moreover, the liquidity crisis faced by regional banks appears to have subsided, and there are indications of stabilization in continuing jobless claims (USCJC). The ECRI weekly leading index forecasts positive US growth, and the Federal Reserve has abandoned its recession forecast. Preliminary assessments suggest that the magnitude of stimulus and interest rate adjustments were appropriately calibrated for a soft landing this cycle, benefiting from the AI productivity boom.
Despite these positive developments, it is crucial to remain mindful of the potential bear case, as markets can be unpredictable. While the current market trajectory is encouraging, there are still worrisome signs that warrant consideration. Being attentive to potential risks and preparing for various scenarios will empower investors to navigate the market’s ascent to new highs and make well-informed decisions amidst changing circumstances.
Is this the End of Inflation?
A few weeks ago, interest rate futures were highly confident, with a 99% probability, that rates would be lower in the next year. However, the current forecast has shifted, and now there is an 87% likelihood of lower rates, with a small 2% chance of rates actually being higher by next July. The shift towards a more hawkish outlook is driven by factors like slow corrections in housing costs and an upward trend in commodities prices since May, indicating a potential continuation of inflationary pressures.
The housing market’s scarcity, with more real estate agents than houses available for sale, contributes to the persistence of high housing prices. Although housing prices are expected to gradually decline, it might take time for things to get back to normal without addressing supply-side issues.
As for commodities, two major concerns are influencing their sustained high prices. Firstly, geopolitical tensions in regions like Africa and the Middle East, along with Russia’s threats of blocking food shipments on the Black Sea, are contributing to the uptick in commodity prices. Secondly, the impact of a significant temperature anomaly affecting crops is raising concerns.
Global warming is exceeding forecasts, leading to fears of a potential climate change tipping point and the possible collapse of the North Atlantic Current. Such a scenario would not only cause further inflationary pressures on food prices but also have a bearish effect on equities in Europe and the US. Monitoring these developments is crucial, as they may significantly influence economic conditions in the future.
Technology Stocks Unrealized Gains
Investors have shown a keen interest in tech companies due to the AI boom, believing they would be the primary beneficiaries. However, I hold the opinion that AI actually erodes the value of its intellectual properties. For instance, with innovations like ChatGPT, it has become much easier and cost-effective for competitors to enter the market and even create open-source versions of major enterprise SaaS products. To maintain a competitive edge, big software firms will need to heavily invest in AI technology, and Microsoft appears to be leading the pack in this regard.
As for the semiconductor industry, the AI boom has been beneficial, driving demand for GPUs. However, rapid advancements in the field have led to reduced compute demands, enabling tasks that were previously resource-intensive to be performed on devices like Colab notebooks. Moreover, the semiconductor market is experiencing an inventory glut not seen since 2001. While chips have historically been a sound investment, we may now be entering a late-cycle phase for the industry.
Considering these factors, I believe the expectations for the S&P 500, especially for Big Tech, might be too high. With a P/E ratio above 26 and profit margins showing a decline, a more appropriate P/E range of 21–23 aligns with the current interest rates and inflation rates. This indicates that multiple expansions may not have much room to lift the market further, and instead, productivity gains will play a crucial role in driving growth.
Show me the Cash
Besides raising interest rates, the Fed is also actively reducing its balance sheet, a move that may create headwinds for stocks. Historically, the liquidity provided by the Fed has been a driving force behind market gains, and its shrinking balance sheet could impact the market’s upward trajectory. There are indications that consumers and small businesses are facing cash flow challenges, with a recent report from the Fed revealing elevated levels of commercial financial distress and a rise in auto loan delinquencies.
While the situation is stable for now, any further tightening of the money supply and job market conditions could pose risks. A resurgence of inflation and additional interest rate hikes may heighten systemic risk. Although we are not predicting a major bear market, it might be prudent to consider some precautionary measures. With the S&P 500 approaching a major resistance level, it could be worthwhile to allocate some funds to cash, bonds, or hedge positions.
At present, S&P 500 puts are relatively affordable, making it a reasonable time to consider protection. Additionally, long-term bonds are currently trading at the lower end of their range since last November, presenting an opportunity for bond investments. In essence, a strategy of modest rotation and rebalancing may be worth considering in the current market environment.
Author Profile
- Lucy Walker covers finance, health and beauty since 2014. She has been writing for various online publications.
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