Stocks have been on a relentless tear over the last five months, with the S&P 500 rising to the 5,000 mark for the first time. Since October 27, the benchmark index has gained nearly 25% as investors have cheered on a strong economy and blowout earnings reports from mega-cap tech stocks.
According to Michael Hartnett, the chief global strategist at Bank of America, such impressive returns over such a short period have only come in 10 instances since the 1930s. But they've only come in one of two market environments, Hartnett said in a March 7 note: at the bottom of a recession, like in 2009 or 2020, or at the start of a bubble, like in 1999.
Given that the US economy is not licking its wounds on the backend of a downturn, the S&P 500 could be floating into bubble territory.
In the note, Hartnett laid out more evidence that a bubble could be developing in stocks. One is how inflated the semiconductor sector has become compared to the rest of the market. Here's the PHLX Semiconductor Sector index (SOX) relative to the S&P 500. Excitement around AI has driven the ratio to all-time-highs, surpassing the prior high seen during the dot-com bubble in 2000, when investors bid up internet-related stocks.
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Second, the semiconductor sector and the tech-heavy Nasdaq are well above their 200-day moving averages, a sign of overextension in the world of technical analysis. Semiconductor stocks are 36% over their 200-day moving average, while the Nasdaq is 16% over, Hartnett said.
Valuations on the "Magnificent Seven" stocks — Amazon, Apple, Microsoft, Nvidia, Tesla, Alphabet, and Meta — are also historically high, with a trailing 12-month price-to-earnings ratio of 45x. The S&P 500, by comparison, trades at a 28x trailing PE, which is also historically elevated.
Still, things can get even more extreme, Hartnett said. During the dot-com bubble, the Nasdaq went 55% above its 200-day moving average, and the "Nifty Fifty" stocks went to a 54x trailing PE during their bubble in the 1970s.
How to know when the bubble is set to pop
Hartnett said it pays to be a "cynical bull," and that investors with this mindset will ride the wave of returns until a few bearish signals arise.
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One of them is when real rates on 10-year Treasury notes rise above 2.5%. Real rates are yields adjusted for future inflation expectations. The current real 10-year rate is 1.6%, according to Fed data.
Second, Bank of America's Bull & Bear Indicator, which measures investor sentiment, needs to be in "Extreme Bullish" territory. The indicator has historically acted as a contrarian signal for future returns. Right now the measure is at 6.4, in moderate territory.
Third, the S&P 500's trailing 12-month PE ratio has to surge above 25x. It sits right around 23 today. The ratio was around 30 in the months leading up to the 2000 and 2022 market declines.
Finally, the Fed has to be ready to cut interest rates. Markets are pricing in the first cut sometime in the middle of this year. Hartnett said a falling number of job quitters shows a weakening labor market, hence the Fed's apparent willingness to cut rates soon.
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"Fed causes bubbles & Fed pops bubbles and in 2024 Fed's determination to cut rates means 'we're not too far from it,'" Hartnett said.
Soft landing ahead?
While Hartnett said a falling quits rate shows the Fed could cut soon, fresh jobs data on Friday from the Bureau of Labor Statistics showed the economy remains resilient.
The US added 275,000 jobs in February, well above economists' expectations for 198,000. Wage growth also grew 4.3% year-over-year, slightly down from January. However, the unemployment rate also rose to 3.9% from 3.7%, and job gains from January and December were revised down.
February's inflation data will be released next week, but January's data showed that prices are still rising at a pesky pace of 3.1%, above the Fed's stated goal of 2%.
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The higher-than-desired inflation rate and hot job market mean the Fed could push out its first rate cut further into 2024, said Alejandra Grindal, the chief economist at Ned Davis Research.
"While it's still highly likely that the Fed will cut this year, a long pause is not off the table given that economic and inflation data has been surprising to the upside," Grindal said in a memo on Friday.
But the economy also seems to be at a fork in the road to some degree, with data giving inconsistent signals. Investors will have to wait and observe the data in the coming months.
Sticky inflation and continued tightness in the labor market could mean higher-for-longer rates. Higher rates weigh typically weigh on economic growth by slowing demand from consumers and businesses. The longer rates remain elevated, the higher the risks for corporations and their share prices.
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Falling inflation and cooling labor market data, on the other hand, could give the Fed permission to start lowering rates, taking the pressure off of businesses and consumers. But it's a fine line. Whether a Fed pivot is a good thing for investors depends on just how cool labor market data becomes.
Hartnett said that a February print below 100,000 jobs on Friday would have put investors' soft-landing thesis into trouble. But the 275,000 print makes it a wait-and-see situation.
"Feb payrolls >225k = no landing, 175-200k soft landing, but <100k likely kick-starts bonds & hard landing price action," Hartnett said.
