As unexpectedly strong economic data and investor enthusiasm for AI have sent the S&P 500 up 32% over the past twelve months, some experts worry that the stock market is in a bubble. Savita Subramanian, head of U.S. equity and quantitative strategy at Bank of America, is definitely not one of them, but after raising her year-end price target for the S&P 500 from 5,000 to 5,400 last week, took the relatively unusual step of saying that “I had heard of quite a few market bears.
Subramanian said in a note on Monday that he had a “full week of negative comments and reactions” since making his bullish call, including a direct question on a call that said something like: “Savita, are you predicting a bubble?” The answer to that question is no, Subramanian insists, and she is ready to address the concern.
In an FAQ published by Bank of America Research, the veteran analyst explained that for all the fears about a potentially irrationally exuberant market, past market bubbles have generally featured a few key factors, primarily “a gap between price and intrinsic value” and “unbridled speculation”—and today’s market does not meet the requirements. “Housing in 2007, technology in 2000, tulips in 1637 are examples that meet these requirements. But today’s S&P 500 is not like that.” , wrote.
Still, with AI fervor stretching back to the Internet era as it pushes some tech stocks even higher, some Wall Street pundits have drawn comparisons to the dot-com bubble. Now, there’s an argument about whether we’re repeating 1995, and the tech bull run is just beginning, or whether it’s more like 1999, and a crisis is just around the corner.
Subramanian assured readers that, in his opinion, it is “more than 1995.” From relatively subdued investor sentiment levels to rising productivity and the fundamental strength of Big Tech leadership, this is not a bubble yet.
Stocks are overvalued, right?
The first criticism of Subramanian’s bullish prediction for the S&P 500 has to do with market valuations. The S&P 500 currently trades at about 20.5 times forward earnings, compared with an average of 15.8 since 1986, according to BofA data.
“The gap between price and intrinsic value is high based on instant PE multiples,” Subramianian admitted. “But the former Magnificent 7 trade closer to long-term average multiples and, more importantly, the current index lacks comparability with previous decades,” in our view.”
The veteran strategist noted that highly valued Big Tech stocks are obscuring the true valuation of the broader market. In his view, the Magnificent 7, a group that includes Microsoft, Google, Apple, Nvidia, Tesla, Meta and Amazon, trade at about 38 times their trailing-12-month earnings, compared with 23 times for the S&P 500 in his set. .
Subramian also noted that the components of the S&P 500 are very different than they used to be, making comparing the index’s valuation to its historical average less valuable.
“Valuation matters. But comparing a PE lag today to a PE lag from previous decades makes little sense given the change in the index mix,” he wrote. “Today’s S&P 500 has half the leverage, is higher quality, and has similar or lower earnings volatility than in previous decades.”
But are investors too euphoric?
The second most common characteristic of any stock bubble is euphoria. And rising AI stocks, led by Nvidia’s 278% surge over the past 12 months, have some arguments that investors are pretty excited about, but Subramanian used some of BofA’s data to push back on that idea.
He noted that investor enthusiasm for U.S. stocks has been “limited” to topics like AI, but overall sentiment is “nowhere near the bullish levels of previous market peaks.” In fact, investor sentiment is about where it was in 1995, according to BofA data. “Sentiment is neutral despite criticism, we hear that sentiment is ‘all bullish’,” Subramanian wrote.
Overall, for Subramanian, despite the stock market rally over the past year, the S&P 500 “lacks signs” of a bubble. “In our view, this bull market has legs,” he wrote, adding that “we are in 1995 today, not 1999.”
The opinion of the bears
While Subramanian has argued that the stock market will experience another banner year in 2024, there are always bears issuing warnings. Just this week, Michael Gayed, portfolio manager at Tidal Financial Group, told motley fool that “we are in a lot of trouble” and that “all bubbles end.”
Investment banks aren’t as worried about a true bubble, but there are some big names, including Morgan Stanley chief investment officer and chief U.S. equity strategist Mike Wilson, who sees the S&P 500 falling about 12%. to 4,500 over the next 12 months. Wilson isn’t arguing that we’re in a bubble, but he points out that 90% of the S&P 500’s “historic” 25% rally since October has been driven by rising valuations rather than improving earnings.
The CIO explained in a note on Monday that he believes the market is being driven by “ambiguity” and “liquidity” this year, meaning investors should remain on the lookout for a correction.
As for the ambiguity part of the market equation, Wilson pointed to “conflicting data” in the economy and the stock market that could be cause for concern. Strong economic growth with moderate profits; rising stock market valuations with a more hawkish Federal Reserve; These are not the typical combinations you would expect. Economic growth typically boosts corporate profits, and the threat of higher rates is assumed to lower stock market valuations. So, what is the reason for the existence of contradictory data?
“We believe the current policy mix explains many of the disconnects that have been difficult to reconcile from an economic, earnings, and performance standpoint,” Wilson wrote.
According to Morgan Stanley’s CIO, federal government spending on the Inflation Reduction Act and the Chip Act is driving spending and hiring by private construction and manufacturing companies, keeping economic growth alive. But there is a problem with this spending that could explain why the gains are not as strong as recent economic data: “While these programs are helping keep the economy going, they are also crowding out the private sector as they affect the cost From handwork. materials and capital,” Wilson said.
So Wilson’s “ambiguity” – or the contradictory data on the economy compared to the stock market – can be explained in part by increased federal government spending. But the second part of the equation is liquidity, which helps explain the difference between the stock market’s strong performance compared to its relatively modest earnings growth, according to Wilson.
This is where the reverse repo mechanism comes into play. To help pay for the federal government’s large budget deficit, the federal reserve allows private sector companies to make a little extra money, often through a middleman, essentially lending money to the Federal Reserve. overnight. These companies buy U.S. Treasury bonds and then agree to resell them at a higher price at a later date, earning yield but providing cash to the Federal Reserve in the short term. The Federal Reserve uses this as a tool to put a floor on short-term interest rates, but it also leads to an increase in liquidity. “In our view, that liquidity has helped lift asset prices overall, led by some of the more speculative areas of the stock market/asset class,” Wilson explained.
Wilson’s argument about ambiguity and liquidity is a long, detailed way of saying “be careful” to investors, because the factors driving market gains may not be sustainable. “Now that the market better understands these dynamics, the burden on earnings and fundamentals is likely to show more substantial improvement,” Wilson concluded.
Subscribe to the CFO Daily newsletter to stay up-to-date on the trends, issues and executives shaping corporate finance. Sign up free.
