The commonly accepted definition of a bull market is when an index gains 20% or more from previous lows and by this measure the S&P 500 index entered a new bull phase on 8 June 2023.

It isn’t a hard and fast definition and there are investors who think it is a bear market rally rather than the real deal. There are good arguments on both sides of the debate and this article discusses them.

Naysayers point to a problem right off the bat which is that the rally has not been broad-based. In fact, that is an understatement. All gains have come from seven companies, which have been dubbed the ‘Magnificent Seven’.

The seven firms are Meta Platforms (META:NASDAQ), Amazon (AMZN:NASDAQ), Alphabet (GOOG:NASDAQ), Apple (APPL:NASDAQ), Nvidia (NVDA:NASDAQ), Microsoft (MSFT:NASDAQ) and Tesla (TSLA:NASDAQ).

According to Bloomberg, gains range from 40% to 180% while the remaining 493 companies are flat. This means the performance of the S&P 500 is now the most concentrated it has been since the 1970s with the top five constituents making up a quarter of the index. In other words, the S&P 500 is losing its diversification benefits.

For investors worried about this, one alternative is to invest in an equal weighted version of the index.

Retail buying of Invesco’s equally weighted S&P 500 exchange-traded fund registered its highest volume since launching 20 years ago, according to Bloomberg.

As well as Invesco S&P 500 Equal Weight (SPEX), which has an ongoing charge of 0.2%, there is iShares S&P 500 Equal Weight (EWSP), where the cost is the same, and Xtrackers S&P 500 Equal Weight (XZES) which is a few basis points cheaper at 0.17%.

The divergence between the two forms of the index has widened to over 10% since the start of the year.

Typically bull markets are characterised by broad participation with most stocks contributing to index gains and rotation between different sectors.

There have been some signs of rotation into the Russell 2000 and regional banking but not enough to be convincing so far. Russell 2000 is comprised of smaller, economically-sensitive companies which tend to be more value-oriented while regional banks have been recovering from the sector crisis triggered by the implosion of Silicon Valley Bank in early March.

David Bernstein, CEO and chief investment officer of Bernstein Advisors, told Bloomberg that the exceptionally narrow leadership in the S&P 500 implies a very bearish economic outlook.

The idea is that if investors can only get excited by a few big technology names it means they are bearish on the other 490-odd names in the index and by default the economy.

Bernstein views the rally as a late-stage speculative blow-off rather than the start of a new sustainable bull run. Morgan Stanley says this month has seen the largest buying spree in terms of net inflows into US equities since 2011, which can be a contrarian indicator.

Meanwhile, the latest Bank of America fund manager survey shows institutions have reduced their cash levels from ‘uber high’ levels, which perhaps indicates some form of capitulation.

For an example of how the flood of money into a few big names is distorting the broader market look no further than the S&P 500’s largest stock.

In early June 2023 Apple made a new all-time high, giving the tech giant a larger market value than the combined market value of the Russell 2000 and larger than all 100 companies in the FTSE 100 index.

SIGNS OF OTHER BULL MARKETS

The S&P 500 isn’t the only index in new bull market territory. There are now 10 indices which have gained at least 20% from last October’s lows.

The technology-focused Nasdaq 100 is up 35%, Japan’s Nikkei 225 is up 22%, Germany’s DAX index is up 34% and the French CAC 40 is up 24% with both the latter indices having made new all-time highs.

The US indices are around a tenth below January’s 2022 all-time highs, but remarkably have regained all the losses suffered since the US Federal Reserve started raising interest rates in March 2022.

WHAT IS THE BULL CASE?

Before chasing markets higher in the hope of making money, it is important to understand the bull case to ascertain if it stacks up and is therefore sustainable.

Stock markets are forward-looking and discount future earnings. With the S&P 500 close to all-time highs it would be fair to say investors don’t appear too worried about an earnings recession.

The case for a new bull market rests on a so-called Goldilocks scenario playing out where the economy cools enough to see inflation come back down towards the Fed’s 2% target without causing a recession, also known as a soft landing.

Bullish investors are therefore ‘looking through’ the current earnings trough and into the next upward phase in the earnings cycle. 

S&P 500 EARNINGS MAY HAVE TROUGHED

According to Howard Silverblatt, senior index analyst at S&P, the latest consensus forecasts call for EPS (earnings per share) growth of 16.4% in 2023 to $201.12 per share followed by a 13% increase in 2024 to $227.28 per share.

Looking at the quarterly data, earnings are expected to decline for the second quarter of 2023 by 6.4% according to FactSet.

If this happens it would be the steepest decline since the second quarter of 2020 when earnings fell by 31.6%.

Analysts are then projecting a second-half recovery in earnings which increase by 0.8% in the third quarter and accelerate to 8.2% in the final quarter.

This turnaround in forecasts can be seen in net revisions data which is the three-month average of upward minus downward revisions to earnings estimates. According to Refinitiv data net revisions are back to zero, having troughed in the spring.

What is interesting at a company level is that the large technology companies are expected to be the biggest contributors to Q4 growth. But, excluding contributions from Amazon, Meta Platforms, Alphabet and Nvidia, S&P 500 earnings growth halves to 4.2%.

For Amazon, Meta Platforms and Nvidia, analysts are pencilling in 100% year-on-year EPS growth in the final quarter according to FactSet.

It is perhaps no coincidence that the big tech names are seeing the biggest share price gains, which merely reflects the pace of their expected superior earnings growth.

There is a disconnect between the earnings recovery that equity analysts are predicting and the recession that bond markets have been pricing for some months. However, not everyone believes in the Goldilocks scenario.

Morgan Stanley strategist Mike Wilson is in the bearish camp. He says: ‘The earnings situation is way worse than what the consensus thinks.’

Wilson continues: ‘We continue to forecast an earnings recession this year that we don’t think is priced in, followed by a sharp EPS rebound in 2024/2025.’

The strategist sees a 20% downside risk to the S&P 500 before paring losses towards the end of the year. In other words, before moving higher Wilson expects the index to trough between 3,000 and 3,300 points.

ARE VALUATIONS TOO HIGH?

In the short-term earnings can be volatile, and the pandemic distorted the picture even more as the economy ground to a halt only to reopen faster than many expected.

One way to smooth out earnings is to calculate cyclically-adjusted earnings. Professor Robert Shiller popularised this method and put his name to the Shiller PE, also know at the CAPE or cyclically-adjusted PE.

Shiller collects inflation-adjusted earnings from the previous 10 years and calculates an average to compare against the price of the S&P 500.

The current reading shows a PE of 30.6 which historically has only been higher on two occasions. In January 2022 before the Fed started raising interest rates and in 2001 close to the peak of the ‘dot-com’ bubble.

It suggests investors are paying a premium valuation, indeed, a sky-high price for the current earnings outlook. At the very least this implies very little risk to earnings.

Some investors might baulk at using historic earnings which is fair comment given the forward-looking nature of markets. Shares has access to a cyclically adjusted earnings model which plots historic and forecast earnings against a long-term trend to estimate a cyclically adjusted PE.

Based on earnings data from 1996 the S&P 500 has a trend earnings growth rate of 5.7% a year. Forward earnings, if achieved, imply investors are paying 24.7-times or one standard deviation above the 35-year average.

Standard deviation is a measure of dispersion. One standard deviation is an extreme reading implying a stretched valuation.

The model is giving the same message as the Shiller PE, that future earnings are already fully priced even if they come in on target.

One final measure to consider is the Warren Buffett indicator which compares the aggregate value of US stocks to annualised GDP. The message from this indicator is the same as the other two. The current value of 172% is 1.4 standard deviations above trend according to currentmarketvaluation.com.

WHY DOES THIS MATTER?

Historically, new bull markets begin when consensus market expectations are already depressed and valuations are low. The current set-up doesn’t fit the typical pattern which suggests the strong rally from last October’s lows is a bear market rally.

The problem is that if US markets are in a speculative blow-off phase there is no way of knowing when it could end. Irrationality tends to lead to even more irrationality.

One approach is to give US markets a wide berth and diversify internationally which is a strategy David Bernstein is following. He told Bloomberg his portfolios currently have their lowest ever weighting to US equities.

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