Top down-market strategy is relevant and sometimes essential when you want to compare the S&P 500 against historical benchmarks. I did this in a series of articles for Seeking Alpha from Dec 2022 to June 2023 and spoke about the same things that market outlook strategists do – historical valuations, poor market breadth, interest rate correlations, smaller categories dominating, and future earnings being misleading especially when they start to falter. I still pretty much look at the macro backdrop every week even now, but it’s a great backdrop, an important framework and benchmark but not a primary factor or thesis for making individual stock decisions. I stopped doing the market outlook top-down series a while ago, when I realized I should get back to my roots and focus on fundamentals getting into the weeds, rather than trying to get better returns by forecasting market direction. As an example, in April-June 2023, I was trying to predict a 3-5 % correction in the S&P 500 when the AI revolution was happening in companies like Microsoft and Nvidia right before my eyes, again ironic because my first article recommending Nvidia was in October 2022.
And that’s been the story for the better part of 3 decades – more success in fundamentals than macro/market direction and technical analysis.
There are several bearish top down-market prognosticators talking about the overpricing of the current market with equally good rebuttals from the bull camp – the correlation with the Nifty Fifty gets the most pushback as does with the 1999 internet bust. There is the concern about poor market breadth with tech stocks hogging too much of market cap and profits, with the rebuttal being the GFC peak. In the 2007-2008 Great Financial Crisis bust, the financial sector had the highest concentration of the S&P 500; financials are typically cyclical with P/E’s rarely exceeding 12-14, and then they were at 20, with expectations of 25% growth, their debt-to-equity ratios were like 33:1 That was an example of ABSURD overpricing!
The point is – it is extremely difficult to compare and predict the bull market euphoria peaks, and to a great extent that time is better spent getting into the weeds of individual stocks and also using the macro backdrop as a variable but not the prime one. Also, how are we going to make better returns trying to time the S&P 500, through downturns or predicting bubbles?
A great company bought at a good price will also go through a drop when the market turns bad – sometimes only because the sentiment has turned and more often on its own demerits and reduction in earnings power, often we’ve overpaid or not taken profits when the going was good. There is no escaping the inevitable downturn, and we try our best to mitigate it. Profit taking is important, not chasing momentum is important; Not overpaying is equally important. Buying quality companies is very, very important. Diversification is important, I do want to have less tech or AI stocks and am always looking out for good ones in other sectors, without getting into value traps just because they’re cheap. There are a bunch of strategists who’re advising buying the Russell 2000 as a de-risking strategy because the gap between the valuations of the Russell 2000 and the Nasdaq 100 is the widest in decades. There is some merit in that, but de-risking is a strange way to put it, because by definition the Russell 2000 has the biggest loss making stocks with the highest earnings risk, and the highest weighting in it is the overpriced SuperMicro (SMCI)!
In terms of macro strategy, I like using the FactSet S&P 500 monthly earnings report, which I follow for the broader Price/ Earnings multiple, earnings and earnings growth. In my opinion, the market is overpriced by about 10% for sure, the last decade’s P/E ratio was about 18-19, we’re at 21 now, with the Index at 5,100 / $245 earning per share.
If you look at the earnings yield of the S&P 500 it is $245 per share / index of 5,100 = 4.8%. The first question you would ask is why am I investing in the market when the 10-year risk free treasury gives me 4.4%, what, am I getting only 0.4% extra for the extra risk?? The historical risk premium in the last two decades has been closer to 1.5%. Even though I ran the numbers from 1962 the other decades have their own idiosyncratic reasons and are not comparable.
In late December 2023, early Jan 2024, I did expect the 10-year treasury interest rates to stay range bound between 3.75% to 4%, with a downward trend moving to 3.25 to 3.5% by the end of 2024, equating to a risk premium of about 1% – given the AI euphoria I wasn’t expecting anything better, and markets do tend to lead, always expecting better times. That hasn’t happened and we’re instead at 4.4% today, which has put a cap on the index and rightly so.
Bottom line – We are slightly overbought and likely to see sluggishness in the index and that reinforces my focus on still finding great companies at bargains, bargains are even more important now.
