Over the past 100 days, the S&P 500 has delivered an impressive 27% return, reminiscent of the initial stages of the COVID-19 rally. This type of rally has occurred only six times in the last 25 years, often signaling further strength in the months or years that follow. However, concerns arise as the stock market is currently at its most expensive level since 1999. As investors question the rally’s sustainability, it becomes crucial to examine key indicators and market dynamics to determine the sustainability of this rally and what comes next.
The Buffett Indicator: An Expensive Market
One important measure to assess market expensiveness is the Buffett indicator, proposed by the legendary stock market investor Warren Buffett. The indicator adjusts the price of the S&P 500 for GDP, providing insight into US stock pricing relative to the size of the economy. Presently, the ratio has reached levels comparable to the market’s peak in late 2021. Despite this, the rally shows no signs of abating, leading some to argue that the stock market no longer correlates closely with the economy.
It’s important to note that high valuation levels do not necessarily mean an immediate market downturn. In fact, historically, the stock market has remained elevated for extended periods, sometimes referred to as “irrational exuberance” phases, before a sharp correction occurs. During these periods, market sentiment and momentum can continue to drive prices higher, fueled by factors such as liquidity and favorable economic conditions.
Liquidity and its Influence on the Market
Since the financial crisis in 2009, the money supply in the United States has steadily increased. This surge intensified in 2020 during the pandemic, with massive monetary stimulus measures implemented by central banks around the world. The liquidity injected into the market has been highly correlated with the performance of the S&P 500. It appears that the market is front-running the anticipated resurgence of liquidity resulting from the Federal Reserve’s decision to lower interest rates in early 2022. The market’s upward trajectory suggests an expectation of increased liquidity.
The significant liquidity injected into the financial system can have a profound impact on the stock market. When there is excess liquidity available, investors have more capital to deploy, which can drive up asset prices. This phenomenon has been particularly evident in recent years, as central banks around the world have pursued accommodative monetary policies to support economic growth. As a result, stock markets have experienced substantial gains in recent months.
Charting the S&P 500 and Money Supply
To gain further insights into the relationship between the S&P 500 and money supply, we can examine historical data. When comparing the S&P 500 relative to the money supply since 1960, a historically consistent pace of growth between the two becomes evident. However, a recent breakout above resistance lines observed in 2007, 2020, and 2022 has led to the S&P 500 entering a zone only witnessed during the late 1990s. This period saw substantial market gains accompanied by a “melt-up” phenomenon. While temporary pullbacks occurred, the market’s strength persisted until 1999, followed by a challenging period for investors ending in the Dot Com bubble crash.
The current breakout above resistance lines suggests that the market may be experiencing a melt-up phase, characterized by a rapid and significant increase in stock prices. During such periods, investor sentiment becomes highly optimistic, and the fear of missing out (FOMO) drives market participants to enter the market, further fueling the rally. It’s important to exercise caution during melt-up phases, as they can be followed by sharp corrections or bear markets.
Examining Credit Spreads
Another important factor to consider when evaluating the market’s health is the level of credit spreads. Credit spreads measure the risk priced into financial markets, with narrower spreads indicating lower perceived risk. Currently, credit spreads have reached levels unseen since November 2021. Low credit spreads indicate market complacency about the future of the economy, as observed during the late 1990s and 2007.
However, credit spreads can remain low for extended periods, as demonstrated in 2021, 2017-2019, 2005-2007, and 1997-1999. Currently, credit spreads are not rising, suggesting that a market top is not imminent but rather indicative of the ideal conditions for a major market melt-up to transpire.
Typically, when credit spreads are rising from low levels, it’s often a warning signal for market volatility. However, while credit spreads provide valuable insights into market sentiment, they should not be considered as standalone indicators.
The Impact of Federal Reserve Actions
The Federal Reserve’s actions and monetary policy decisions have a significant influence on the stock market. Rate cuts during recessions have been a bearish signal for the stock market. However, instances where the Federal Reserve lowered or paused interest rates without an accompanying recession have typically resulted in favorable stock market performance. This scenario, combined with the accelerating artificial intelligence (AI narrative), which benefits large-cap technology stocks, suggests a favorable environment for market growth.
The Federal Reserve’s intent to lower interest rates in 2024, despite the absence of an economic recession, signals the central bank’s commitment to supporting economic growth. Lower interest rates make borrowing cheaper, stimulating business investment and consumer spending. This favorable monetary policy environment, coupled with the positive sentiment surrounding AI and its potential to transform various industries, contributes to the market’s upward momentum.
The Role of AI and Market Potential
Artificial intelligence (AI) is a transformative technology that has the potential to revolutionize industries and drive economic growth. Companies such as Microsoft, Google, Amazon, and Nvidia have heavily invested in AI startups and dominate the global cloud market, which serves as the foundation for AI operations. These AI-exposed firms comprise a significant portion of the S&P 500, accounting for around 20% of its value.
Investors are increasingly optimistic about the prospects of AI and its ability to enhance productivity, streamline operations, and create new business opportunities. The positive market sentiment surrounding AI has propelled the stocks of these companies to aggressive upward momentum. As a result, the stars seem aligned for the onset of a melt-up phase.
AI’s potential impact extends beyond the technology sector. It has applications in healthcare, finance, manufacturing, transportation, and many other industries. As AI adoption grows, companies that successfully leverage this technology are expected to benefit from increased efficiency, cost savings, and competitive advantages. This optimism surrounding AI’s transformative potential further contributes to the market’s upward trajectory.
Market Outlook and Potential Risks
Barring an economic recession, the S&P 500 rally could continue its upward trajectory, possibly reaching 6500 points. Historically, economic recessions have caused a decline in the S&P 500-to-money supply ratio. However, we do not anticipate a recession until the latter half of 2024. In this context, a rise in price-to-earnings (PE) ratio from current levels of around 21 to 23, reminiscent of 2020 and the late 1990s, does not appear far-fetched.
It’s important to note that market predictions are inherently uncertain, and unforeseen events can significantly impact the market. While the current market conditions and indicators suggest a favorable outlook, risks and challenges remain. Geopolitical tensions, changes in government policies (especially with elections coming up), inflationary pressures, and unexpected shocks to the global economy are among the potential risks that could disrupt the market’s upward trajectory.
Considerations and Cautionary Factors
Despite the market’s strong performance, it is worth noting that the S&P 500 has not tested its 50-day moving average in over 137 days, the longest streak since the significant rally of 2020. Typically, even during robust bull markets, the S&P 500 revisits its 50-day moving average multiple times. The lack of a pullback or correction during this period raises considerations about market health and the potential for a market “overextension.”
Should price action return to the 50-day moving average, it could provide an opportunity for investors who have been waiting on the sidelines to enter the market. This influx of new capital should push the market higher.
Conclusion
The current rally in the S&P 500 is impressive and reminiscent of previous market rallies. Various indicators, such as the Buffett indicator, liquidity levels, credit spreads, and the impact of Federal Reserve actions, suggest that the rally may have room to continue. The presence of dominant AI-exposed companies and the positive market sentiment surrounding AI’s transformative potential further contribute to the market’s upward momentum.
While the rally appears strong, caution should be exercised. The market is currently at its most expensive level since 1999, and the absence of a test of the 50-day moving average for an extended period raises considerations about short-term market health.
