Is the S&P 500 a High Risk for Investors?

July 3, 2023No Comments

Hello and welcome once again to the Smart Money Dumb Money Show. I am your host as usual, Keith Richards. I’m President and Chief Portfolio Manager of ValueTrend Wealth Management, and I’m a technical analyst. Today we’re going to look at some charts. What else is new, right? So we’re going to cover whether the S&P 500 is, from a valuation and from a technical point of view, maybe a little bit higher risk than some of the other broader indices out there. It’s not going to be a long presentation. I’m just going cover a few important slides, and I’m going to leave you to decide what your thoughts are, rather than me try to present a strong case, although you’ll see my bias as I present these slides. So let’s just take a very quick look at a quick slide presentation I put together. I like using PowerPoint when I have different images from different sources.

I just throw it all in one PowerPoint. So the question is, is the S&P 500 a high risk index? I’m going to start off with a quote that I used. It came out of a part of a fairly lengthy quote that I took from David Rosenberg, and I’m sure a lot of you know who David Rosenberg is. So he’s a very, very, very well regarded Canadian economist, super smart guy, has worked with massive firms like Gluskin Sheff. He is an analyst and his research is used by most of the large institutions out there, and I do get his newsletter as a minor client of of his, but I really do think that he’s a guy that’s worth listening to. Now, I don’t always agree with him, and he is pretty bearish right now.

I don’t know if I’m fully bearish, but I do want to point out a thought of his just to start off this particular webinar. And that is that he noted that he feels that people are kind of lost on just how this particular rally that we’ve been in since the beginning of 2023 is not a low risk rally. His quote was, “Is it lost on these people that even with a modest broadening out of late, that the vast majority of S&P 500 sectors are still well off their peaks?” So this is basically him talking about breadth. So he’s being like a technical analyst here, and he’s talking about the lack of participation by almost everything else except for basically seven or eight stocks.

I’ve talked about this a little bit, maybe too much lately, but I think it bears repeating because I’m not the only one noticing this. It’s not just a few of us technical people, it’s people like David Rosenberg. So let’s go to the first slide. What I want to do is, from a technical perspective, I want to point out that the S&P 500, which is this black line, you can see has broken out. You can see that there’s the old resistance point around 4200. Well, here’s 4,200, sorry, that was around 4,100. But the old resistance point that I talked about a lot and, and even a cluster here that the market broke out quite nicely from, that’s the black line. The red line is the New York Stock Exchange Composite Index, and that’s made up of a much broader spectrum and a much less overly concentrated weighting in technology stocks.

And you can see that it is still struggling to break out. It’s done nothing, in fact. So this is basically telling us that if you looked at the market as a whole, it’s still basically going sideways. It’s basing. It’s not broken out at all. That’s not a bad thing, but it’s not a good thing either. It’s just in that phase of the market that happens after every bear market where a market consolidates. The S&P 500, because it’s so technology weighted, is kind of fooling us, isn’t it? It’s really painting a different picture than reality. And reality is that most stocks and most sectors are not doing that well, and that’s what David Rosenberg is talking about. A couple of lines down here. This is a correlation line. So you can see normally the correlation between the New York Stock Exchange average and the S&P is actually reasonably high.

So the S&P by itself is not such a bad index, although at times, such as when technology is going a bit bananas as it did in late 2021, and you remember what happened after late 2021, don’t you? You remember there was this nasty bear market that came along in 2022. Well, the correlation dropped, and in fact, if you look at right now, the correlation has dropped drastically. And that’s, again, not a great thing as history has shown us. So we’re seeing that the two are moving separately in direction. You can see that here, this line is the S&P 500 versus the New York Stock Exchange average. You can see when the line is moving down, that means the S&P is underperforming the average, and when it moves up, it’s outperforming the average. You can see there is a bit of weighting here, but the movement, the sharpness, the parabolic look of the recent outperformance by the S&P 500 versus the New York Stock Exchange is just insane.

It’s massive as I note it on my chart here. So this should be concerning to investors, because this can last a while and we are starting to see, as you note up here, you we are starting to see that some of the stocks on the broader markets are picking up and I noted this on my BNN show recently. I said, yeah, we’re starting to see the beginning of some improvement in market breadth participation, but it’s really early yet. So we don’t want to hang our hat on that just yet. It’s not an absolute, there’s some signs of improvement. So let’s look at the next chart. This is as of Tuesday the 27th open.

This is how certain stocks performed this year, and it really shows you where the performance has been. Look at the performance of these stocks. Nvidia Meta, Tesla, AMD, Apple, Microsoft, Google. Like 200% on Nvidia in six months, come on. Is it that much more fair value, 200% better in six months? So that’s where the action’s been. Now take a look at a very wide collection of stocks that are in a wide variety of sectors. Home Depot, building supply; Goldman Sachs, bank; Verizon, communications; on and on, Target, retail. I just keep going down. Telus, Pfizer Drugs, right? CVA Drug Store. So Dollar General at the bottom. Look at the performance of these stocks.

Well, the S&P has gone up double digits over this first six months. It’s certainly not been on the back of some of the biggest names. In the red column here, some of these are some of the biggest names of the biggest sectors that we have on the markets and these guys are underwater in a market that’s gone up. It’s a much broader number of stocks and a much broader number of sectors. You can see where all the action been has been in one sector so just keep this in mind. You may think, well, that’s still a healthy market, and truthfully at the beginning of a breakout, that can be okay. It can be okay, you get market leadership, but if it lasts for too long, and I would maybe propose that six months is starting to get into the too long part of the equation.

If we don’t see more of that improving breadth, I’ve got to wonder if this rally is going to last. So let’s take a look at one last thing, and that is a fundamental. I’m using the “F” word Fundamental. So this is a fundamental calculation. It’s Morgan Stanley and Morgan Stanley has something they call an equity risk premium. Basically what they do is they take all those stocks that are on the S&P 500 and they project their forward earnings based on earnings reports and conferences and all that sort of stuff that they listen to. They say, okay, here’s what we expect in the next 12 months for earnings. It’s a forward earnings projection and you know, that can be wrong. So this is just based on their research, right or wrong, but they come up with a projected earnings, therefore for the S&P 500.

Then they compare that. They take a look at what the PE ratio would be in the current type of environment and say, this is what the stock market might end up at. And you guys know as much as I do, it’s not always super accurate, their projections, but it’s a guideline. We can look at the history though of when their earnings are suggesting a lower return compared to the 10-year bond return. That’s why it’s called the equity risk premium, because let’s say that the projections were that you could make 5% on stocks based on their calculations over the next year, but the rate of return on a 10-year treasury bond was 4%, just for argument’s sake. So the difference is 1%. You’re trying to make an extra 1% by taking all that risk of being in equities.

That’s a pretty lousy trade-off. So that’s what it means by equity risk premium. It doesn’t mean that the market can’t go up. What it means is, is that would you have done better, or at least from a risk adjusted point of view, would you have done better if you had just stuck to a boring old treasury bond and made your absolute guaranteed 4% yield over the next 10 years? The day you buy it, if it’s 10%, you’re locked in at 4% yield and you’re going to get that 4% return because the US Treasury is the one treasury you can definitely get your money back on, and you can definitely make your 4%. They don’t renege on any of this stuff. Nothing changes. So that’s what the equity risk premium is. And you can see there are times, whether you think Morgan Stanley’s earnings estimateS&Projected possible returns on the market are incredibly accurate, and they’re probably not, but it’s a general rule that when their equity risk premiums get too low, meaning equities have too much risk compared to buying a 10-year bond, things can get ugly.

You can see that coming into the 2008 crash. So there’s 2008, the equity risk premium was low and sure enough the market went down. Funny enough, when the market went down then the equity risk premium was huge. Because why? Because the earnings were likely even if they were going to be lower, but stocks were so depressed, it was opportunistic when compared to buying a 10-year bond. So that’s why the indicator went up here. The point of this chart is, this is from Bear Traps, I should acknowledge that, they’re trying to show you that after a super low point, you often get a selloff, and then that selloff creates opportunity and you can get a 500 basis point spread. So you’ll notice that during minor and major crashes like 2008, and then this one was 2011.

I’ve been in the business an awful long time. I started my career in 1990, actually late 1989, but I wasn’t licensed then so let’s call it 1990. So I’ve been in the business for 33 years plus. And I will tell you that in 2011, I remember it very clearly, that summer the market fell and it fell about 25% in the course of about a month or two. Equity risk premiums were low, the summer crash. It wasn’t a massive crash, it was a 25% correction. It didn’t last too long, but it created an opportunity. So this is where the opportunities are. This is where you should be concerned. Look where we are right now. There’s COVID right there, by the way. The equity risk premium in 2018, just a couple years before COVID, were pretty lousy.

It was like the tradeoff to buy stocks versus the risk of those stocks versus the potential return was not great. And eventually that came about. Now you could say, well, that was COVID, but no. I’ve always said that the market is waiting for an excuse to reach its proper valuation. I liken it to a balloon. The balloon is too tight when this risk premium is down here. It’s too tight and then somebody comes along with a cuff link, and the cuff link scrapes against the balloon and it pops and everybody blames it on the cuff link. Everybody blames it on the COVID crash or whatever. But in reality, whether this was a tech bubble and this was I think oil and gas sell off or whatever it was in 2011, the problem was the valuation to begin with.

It wasn’t necessarily the guy with the cufflink. So where are we now? Well, we’re in this like uber high risk zone. In other words, the equity risk premium right now is so lousy on the S&P 500, but I would bring you back to that New York Stock Exchange average and say it’s probably not so bad on a lot of the other sectors. But because the S&P 500 is something like 30% weighted in those crazy tech stocks, you have a equity risk premium that is crazy lousy, like really low and in fact, lower than it was coming into 2008. That’s how bad this market is set up from the Morgan Stanley risk premium model. Even if they’re off somewhat, they’re not going to be off that much. The point I’m trying to make is that the S&P 500, not necessarily more broadly based markets, not necessarily all the sectors within the S&P 500, but because the S&P is so weighted in that group we just looked at, these guys, that’s a problem for investors who just want to buy the S&P 500.

You are buying into a market that you could probably, from a risk reward point of view, do better in a 10 year bond right now from a buy and hold yield only perspective, not on what the bond market might do over the next year or two. So just keep this in mind. This is what I wanted to leave you with today, was that I’m not a fundamental guy. I’m not making as assertations on what the market might do based on the Morgan Stanley model or anything else. But I can tell you, as I said recently on my BNN show, and as I’ve quoted on a recent blog, you might want to read it if you haven’t. It was called Quotable Quotes. I’ve been pointing out to people, I’ve been pointing out to you, my readers and viewers of these videos, that the tech part of the market is where the danger is.

And the more you move towards Nasdaq and S&P 500 holdings, the more risk on a relative basis doesn’t mean the market’s going to crash, but it means that you’re taking on more risk. That much I’m going to say, because I’ve been doing this for a third of a century, and I can tell you that narrow breadth markets with high invest investor enthusiasm through the sentiment indicators that I’m seeing right now, basically never end out well. So something’s got to change. Breadth has got to change for those concentrated indexes to continue their breakouts. Or we want to basically stay out of those groups and maybe focus on value stocks and even some cash. So take it for what it’s worth. You could argue as a momentum investor that you want to stay in the tech stocks, and I won’t argue with you because that’s a very valid point of technical analysis. We call ourselves ValueTrend for a reason. Cause we’re value investors and we don’t want to buy into hype. We don’t like parabolic moves, but hey, some people make money in parabolic moves. You just don’t want to be the last person to be in that overcrowded elevator because then the line snaps and it goes down with you in it. Hope that helps, and we’ll see you again in a week

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