Head of Saxo Strats
Summary: Concentration and valuation risks are coming back into US equities as May 2023 is ending today. The rally this year has been predominately driven by technology stocks and especially recently AI-related stocks. The narrowness of the rally and the fact that US equity valuations are back to levels not seen since July 2022 are elevating risks for investors and lowering future expected returns.
The total return in S&P 500 this year is 10.3% as of yesterday’s close, but the rally has been extremely unbalanced as we have written extensively about in this year’s equity notes. Just look at the best performing stocks this year. Starting with Apple as the biggest stock in S&P 500 with a market value of $2.79trn at the bottom of the performance table and moving upwards see total returns year-to-date of 37% or higher indicating the wild performance of not only technology companies but especially the largest stocks in the index such as Nvidia, Meta, Tesla, Amazon, Alphabet, Microsoft, and Apple. Concentration risk and narrow rallies in equities are often not good signs as they reflect a narrow theme played by the market and thus things can quickly turn around if the theme is sold off again. One potential catalyst could be a weaker than estimated US economy over the summer months.
The rally in US technology stocks this year, and in particular AI-related stocks, due to the market pricing in Fed rate cuts as the Fed will be forced to respond to lower economic growth, has pushed US equity market valuations to the highest level since July 2022. As we wrote in yesterday’s equity note, the global semiconductor industry has reached the highest equity valuations since early 2010 as growth expectations for semiconductors due to trends such as AI, electric vehicles and data center have fever levels. It almost feels like an echo from past bubbles.
Our combined equity valuation index on US equities reached 0.82 standard deviations above the historical average since 1992 up from 0.21 in September 2022. In other words, the US equity market never repriced below its long-term average underscoring the strong sentiment in US equities. If we look at what the current equity valuation means for future returns, based on past patterns, then we can see that the expected 10-year annualised real rate return is between -3% to +3% suggesting significant downside risks relative to the long-term average of +5% real rate return. Lofty equity valuations often goes hand in hand with overextended equity valuations in growth pockets of the market leading to subsequent outperformance of value stocks, which AQR co-founder Cliff Asness also recently predicted at the Morningstar Investment Conference.
2024: The wasted year
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Markets are driven by election optimism, overshadowing growing debt and liquidity concerns. The 2024 elections loom large, but economic fundamentals and debt issues warrant cautious investment.
As US economic slowdown hints at a shift away from exceptionalism, USD faces downside with looming Fed cuts. AUD and NZD set to outperform as their rate cuts lag. JPY gains on carry unwind bets and BOJ pivot.
Amid AI and obesity drug excitement, equities see varied prospects: neutral on overvalued US stocks, negative on Japan due to JPY risks, positive on Europe. European defence stocks gain appeal.
With the economic slowdown, quality assets will gain favour, especially sovereign bonds up to 5 years. Central banks' potential rate cuts in Q2 suggest extending duration, despite policy and inflation concerns.
Commodities poised for rebound. The "Year of the Metal" boosts gold and silver, copper awaits rate cuts. Grains may recover, natural gas stabilises. Gold targets $2,300-$2,500/oz, copper's breakout could signal growth.
