If you've been sitting on the sidelines of this rally, it can be tempting to jump in.
The S&P 500 is back within an earshot of its January 2021 all-time high as it rides what is now a 24% upward charge back into bull-market territory.
But it's best to ignore the animal spirits within you fueling the envy and fear of missing out, says Bill Smead. That's what he did in 2020 when the ARKKs of the world were skyrocketing, and he crushed the market the following year by sitting in value stocks.
Not chasing hot stocks has worked well for him over long timelines. His Smead Value Fund (SMVLX) has beaten 99% of similar funds over the last five years and 97% over the last 15, Morningstar data shows. And the founder of Smead Capital Management is betting his strategy work for him again when the hype around artificial-intelligence stocks sputters out.
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For Smead, the signs are obvious that this is a speculative episode. Year-to-date, only seven stocks have driven basically the entirety of the S&P 500's returns: Apple, Amazon, Tesla, Microsoft, Meta, Nvidia, and Alphabet.
That means bad news for the broader index when the episode is over, he said.
"Unfortunately, the market for most stocks will be affected by the damage which will be done when this fad hits the wall and does the normal destruction that occurs when financial euphoria gets unwound," Smead wrote in a June 27 note. "Fear stock market failure!"
He compared the concentration in several stocks to other manias, like the "Nifty Fifty" era in the early 1970s, the dot-com bubble in 2000, and shares of RCA in 1929.
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3 charts that show why we might be nearing the end of the rally
In the note, Smead shared three charts that show"how late we are in this particularly long-lasting mania for tech stocks."
The first is of S&P 500 call-options volume, which is at record highs, meaning investors are excessively bullish on current momentum.
Second, the top seven stocks in the S&P 500 have a collective price-to-free cash-flow ratio near 70. That's much higher than over the last decade as the ratio has skyrocketed since early this year on AI-related developments. This means investors are now paying a higher premium relative to current cash flows to own the stocks, as they anticipate future success.
And third, the tech sector of the S&P 500 is hitting valuation levels last seen during the dot-com bubble. Below, Smead cites the sector's price-to-earnings-to-growth ratio (orange line), which accounts for longer-term growth.
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The bigger picture
Poor market breadth as overzealous investors pile into AI stocks has been a concern cited by many strategists in recent weeks.
"Sentiment and positioning has turned outright bullish as both retail and institutional investor sentiment has reached its highest levels in over 2 years and registered readings in the top quintile of the past several decades," said Mike Wilson, the CIO and chief US equity strategist at Morgan Stanley, in a June 20 note. "However, given our fundamental view on growth, we find it hard to get on board with the current excitement and narrative supporting it. While breadth has stabilized, it remains far from supportive of higher prices."
Valuation has also been a concern, especially with pressures on economic growth building.
"Investors who have driven up valuations based on expectations of strong earnings growth are likely to struggle with the impact of softening revenues on earnings while living in a world with the 2- and 10-year yields north of 5% and 4%," said José Torres, senior economist at Interactive Brokers, in a client note on Friday.
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Given the gusto with which stocks have rallied since October, the average Wall Street strategist is now bearish on the direction of the S&P 500 for the remainder of the year: the average target is around 4,000, or about 10% off of the index's current level of 4,450.
But if the US economy manages to avoid recession, stocks could stay elevated, and the rally could become more robust with broader participation. Right now, the labor market is still strong, with unemployment at 3.7%.
Whether or not that holds true will become known in the months ahead. But a Federal Reserve that insists it will keep rates elevated, a bond market signaling trouble ahead, and slowing manufacturing activity point to a coming downtrend for the economy. And that could mean the end of AI-driven speculation and therefore the S&P 500's rally, too.
