US Markets are Red Hot in June!

While it’s Canada Day, it’s the US with reasons to celebrate their Independence Day. The US indexes have once again pushed higher, while the Canadian index has felt the pain of the New Captial Gains tax. This has pushed Canadian stocks in the opposite direction as investors harvest lower-cost gains before the deadline. The US markets look overbought and we are now moving focus from inflation to employment.

Topics

Canada Capital Gains Sell-Off
US Valuations and Indicators
Move over Inflation, Employment is the new king in town
US Recession Unlikely

Canada Capital Gains Sell-Off

To think a higher tax would not affect investing would be pretty silly. Capital investment is a very large part of economic growth and it is what makes the US such an economic powerhouse. They have the best capital markets and this allows companies that need capital to get it. The new capital gains tax came into effect and to take advantage of the old rate you needed to sell before the 24th. Here is a one-month chart of the Toronto Stock Exchange (Green and Red) and the TSX Venture (Purple).

There was a lot of selling in the middle of the month as investors wanted to harvest those cheaper gains. While this does not make the market, it is interesting to see the effect government policy has on the markets. This was at a time when the US markets did have one of their best months of the year. Whether this will prevent future investment is undetermined but it did affect stock selling going into it.

US Valuations and Indicators

The S&P 500 seems to go up every week without ever looking back led by the Magnificant 7 stocks. There is a lot of justification for this performance as they account for the majority of the profits that companies make in the US. This has brought the Top 3 companies (Apple, Microsoft, and Nvidia) to now represent 20% of the index. The same companies are about 25% of the NASDAQ and the Top 7 companies (adding Amazon, Broadcom, Meta, and Alphabet) now represent 33% of the S&P 500 and about 45% of the NASDAQ. Therefore, much of the movement is based on these 7 companies. This concentration can either be a blessing or a curse, there is a case for both. When we are this concentrated, the market moves in the most dramatic ways. For example, if Apple were to miss iPhone sales then the market would move dramatically along with it. If they were to exceed projections you would get the same movement upwards. Therefore, there could be some volatility in our future.

Valuations

Here are some charts that we follow to show the current valuation of the S&P 500 which gives us some cause for concern.

Price Growth vs. Earnings Growth

This is about a month old but does show the rapid price acceleration vs. the expectation of future earnings of companies in the S&P 500. Price growth has exceeded earnings growth and any slowing in earnings growth could have a large impact on price. Most downturns happen PRIOR to earnings revisions, not before them. 

Shiller PE Ratio

The Shiller PE Ratio is great because it takes into account the effect of inflation on earnings increases. This is helpful because inflation is higher than the historical average therefore many numbers appear better than they actually are. On this chart we are outside the historical average over the past 10 years, the market very seldomly stays outside 1 standard deviation away from the average. COVID was a large outlier, when earnings did go negative for many industries bringing down the average significantly.

Buffet Indicator

This chart is also a little out of date but lucky for us the market has moved up since April 30th, and this would bring the value even higher. Warren Buffett is holding a lot of cash because of the current value of this indicator. Which takes the Top 5000 US stocks' total value and divides it by US GDP. The thought would be companies cannot venture too far from the actual economic growth of the US economy. This indicator shows a valuation vs. GDP that has only been reached a few times in history. This indicator kept Buffett out of the market in 2000 and during COVID and afterward was able to pick up stocks cheaply when they dropped. 

Indicators

Two indicators we do watch are in “cautious” areas.

Sahm Rule

The Sahm indicator does not track actual unemployment levels, but rather the pace of unemployment. This is because if there is a fast change it would “shock” the economy. This indicator is getting to the “cautious” zone but is not indicating a recession.

Yield Curve

This one most people are aware of but it is the inversion of the yield curve. This is a very common recession indicator and does represent the phrase “the fed stays too long”. This is saying that they leave rates too high for too long and damage the economy. After this, they have to react quickly and drop rates to help spur economic activity. While this is not a guarantee because the Federal Reserve can get rate reductions correctly, which they have not done very well it is always possible and they are more educated now than in the past. Therefore, once again “cautious” zone.

Move over Inflation, Employment is the new king in town

These indicators are guides and give us an idea of what the market is expecting. Right now with high valuations and indicators where they are, it would suggest the market believes the economy will be strong enough to hang on until inflation drops to 2%. Inflation has moderated quite a bit and now the more important part is making sure the economy is not harmed. The bad signal would be a sharp increase in unemployment and then it would confirm the Federal Reserve is too far behind. If employment can remain resilient and inflation hangs in and moderates further, these valuations can hold.

In the US, employment has been strong this year but did tick up to 4.0% last month. 

There is not an expectation for employment to rise higher but it is not difficult to see the chain of events that could happen if it were to tick up marginally. 

US Recession Unlikely

With all of these valuations and indicators, it does NOT appear the US is heading into a recession. Unemployment is low, company earnings are improving, and there is a lot of government spending to stimulate their economy. But given valuations and high concentration, a softening in the economy could produce a stock market pullback. Which would not be a recession but rather a correction in the indexes. This would be healthy and part of a normal performing market. 

In July-November of 2023, the S&P 500 corrected 10%. Big Tech corrected about 15-20% during that time and pulled down the indexes. It would not take much economic weakness to cause this type of correction in the S&P 500. 

Summary

Markets are doing well led by the top 7 companies and stock prices continue to climb. We would be cautious in this scenario given the current valuations, while we don’t believe the US is heading into a recession, it would not take much economic weakness to cause a correction in markets.

Justin, Konrad, and Merriel

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More articles and information are available at www.knowprotectgrow.com 

Content Sources: Bloomberg, Trading Economics, Yahoo Finance, BCA Research

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