Unsure how long this AI bull has? Bonds now offer a cushion at the best values in years
CNBC · C · trust 53/100
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"It gets late early out there," was Yogi Berra's illogically brilliant take on the late-summer left-field shadows at the old Yankee Stadium.
Also works pretty well as an assessment of today's markets, where constant assurances that the AI theme is "still early" and widespread belief in unceasing economic momentum coexist with some late-cycle characteristics.
S&P 500 operating-earnings growth in the second quarter exceeded 30% and is projected to hit that threshold again in the third, yet the index itself is merely 2% above its June peak from before those stellar results were reported.
The S&P forward P/E has compressed from 23 a year ago to 19 today, which can be read as a signal both that investors are reluctant to pay up for current record profit margins and next year's decelerating growth — and that rising government-bond yields are relevant to the aggregate cost of capital for companies.
Consumer spending has held up fine, because unemployment is low and Americans spend what they make, though real incomes have begun to lag inflation, requiring some dissaving to support consumption.
Corporate-debt spreads have begun to rise in recent weeks from historically tight readings, as technology bond issuance and Treasury volatility combine to test investor risk appetites.
And, of course, the Federal Reserve has transitioned from last year's "insurance" rate cuts to a rate hike, with market expectations of a couple more, which while digestible in a strong economy at least raises the prospect of restraint on an expansion that's carried on for more than half a decade.
Every one of those items can be spun as mid-cycle adjustments, of course, and they may well be. In dynamic markets not governed by a clock, "getting later" is not the same as "almost over." It's tough for an economy to veer quickly into a ditch when the government is running deficits of 6% of GDP while the private sector is investing in new productive assets in multi-trillion-dollar bursts once reserved for emergency government stimulus measures.
And if the valuation compression in the AI-buildout bellwethers is a signal that investors are mindful of an eventual growth plateau, it is also the best argument against the criticism that AI equities are in a bubble. Micron still trading 15% below its June peak and Nvidia sitting at such a steep discount to the market P/E and that of defensive, capex-light Apple , suggest a level of sobriety that – all else equal – could mean that some risk has been drained away.
The extraordinary dissonance in market behavior has made it tough to infer clear macro signals. For weeks, historically anomalous statistics have piled up: Never before have so many new 52-week lows registered with the S&P 500 either up on a given day or so close to a record high.
Treasury yields making new highs has exacerbated the arrhythmic action, as pressure on cyclical parts of the market propels money into the rate-insensitive AI-levered tech giants, which produces all those new lows as the S&P 500 carries higher. In this market moment, very few index rally days are emphatic, no selloffs are fully bereft.
After a June 2 all-time high of 7620, the S&P 500 went sideways in a narrow range for two months and two days until breaking higher to a fresh, if marginal, new record on Aug. 4. Today is two months and two days since that breakout, and the index has merely gone sideways in a narrow range but enters the day about half a percent from another new high.
Yet since the Aug. 4 pop above 7700 for the first time, the median S&P 500 stock, the Russell 2000 , the KBW Bank Index and the equal-weighted consumer-discretionary sector are down between 4% and 11%.
There have been times when this kind of unsettled action generates more stress than the broad indexes can absorb, such as in late 2018, when tightening financial conditions and internal market weakness in a mid-term election year caused the S&P 500 to drop nearly 20% into year-end, even with earnings growing 20% and no recession in sight.
That, granted, was a brief if treacherous gut check, giving way to a re-expansion of valuations and a march to new highs through 2019 right up until Covid struck.
Dean Curnutt, founder and CEO of Macro Risk Advisors, articulates the challenge facing risk-aware investors: "The US Treasury market, long referred to as the 'risk-free' asset, is more likely a sponsor of risk than a stabilizing asset in a portfolio…As stock/bond correlation pushes portfolio volatility higher, the correlation among stocks drags it lower. Much lower. The realized correlation among stocks in the SPX over the last 6 months is 4%. This inconceivably low level of correlation is Ozempic for volatility at the index level."
Of course, many people tolerate Ozempic well and are healthier for it. The current market structure has been remarkably generous toward undiscriminating passive index investors. The S&P 500 – by growing more leveraged over time to the strongest secular-growth theme while sidelining disrupted or cyclically vulnerable ones – has protected its owners from deeper drawdowns.
At some point, presumably, the AI-tech dominance of the index will carry too far and the S&P 500's great structural sheltering mechanism will leave it exposed to a bust cycle and a wave of capital destruction. Against that daunting but impossible-to-time prospect, the bond market is now offering a cushion at the best values in years.
This indicator from John Kolovos of Macro Risk Advisors uses several data points to reflect both what investors are saying and what they are doing.
Kolovos on the latest reading: "Bullish sentiment abated last week on the heels of tightening…
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