It’s been a fantastic year for mega-cap tech stocks, which have defied all the economic gloom to stage a stunning comeback. The risk is that this rally is approaching its ‘finale’ in an environment where valuations are stretched, earnings are stagnant, and liquidity flows are about to turn negative.
Tech party
News flow this year has been quite gloomy. A series of bank failures, a deepening contraction in the manufacturing sector, persistently high inflation, and rising interest rates have been front and center.
Yet, stock markets have been euphoric. The tech-heavy Nasdaq has gained more than 25% so far this year, with Nvidia being the rockstar of this index, having risen 156% on hopes that its graphics cards will power the AI revolution. Meta Platforms is up 119%, Tesla has jumped 82%, and even Apple briefly hit a new record high lately.
Meanwhile, measures of market stress such as the VIX have fallen to their lowest levels in two years. This suggests that demand for downside protection has evaporated, as investors don’t feel the need to hedge so much anymore.
Liquidity pulse
Behind this massive rally lies the incredible force of liquidity injections. Starting in October last year, central banks in Japan and China flooded their financial systems with stimulus, countering the Fed’s quantitative tightening programs.
That was exactly when stock markets bottomed, which is probably not a coincidence. Combined, the Bank of Japan and the People’s Bank of China have injected around $1.3 trillion into their financial systems since October, while the Fed has only reduced its own balance sheet by $300 billion over the same period.
Hence, there was a net-liquidity injection of almost $1 trillion finding its way into global markets. When such a tsunami of money is unleashed, it naturally pushes all boats up. But it’s the riskiest assets that gain most, helping to explain the dramatic outperformance of tech shares, unprofitable companies, and cryptocurrencies.
Built on shaky foundations
It is so difficult to trust this rally because it has not been matched by an increase in corporate profits. Earnings for the entire S&P 500 are essentially stagnant from last year. In the tech sector, earnings are down 8.5% year-on-year, even though this group has spearheaded the advance.
Since profits are flat or falling, all that has happened since the markets bottomed nine months ago is that valuations have gotten more expensive. The S&P 500 currently trades for 18.1 times what analysts think earnings will be over the next year.
That’s expensive from a historical perspective, but it’s almost ridiculous when you consider that earnings are not growing and could even contract in the coming quarters as the economy continues to slow.
Analyst estimates suggest corporate America will return to earnings growth in the third quarter of this year. Alas, that’s exactly when the lagged impact of all the Fed’s rate increases is likely to be felt in the economy, making it seem a little unrealistic.
Liquidity goes into reverse?
Looking ahead, the liquidity impulse that has carried markets higher is likely to go into reverse soon. China and Japan have already started to taper their money printing, while the Fed and ECB continue to drain liquidity via their quantitative tightening programs.
Meanwhile, the US Treasury will need to rebuild its cash balance over the next few months now that the debt ceiling has been lifted. The plan is to raise its cash levels to $600 billion by September, which can reduce bank reserves and remove liquidity from financial markets, depending on who buys all the bonds it issues.
Blending everything together, it seems like the sensational rally in risk assets might be approaching its conclusion. In the short term, a lot will depend on whether the Fed raises rates next week. Overall though, valuations seem excessively optimistic as they are not underpinned by rising earnings, which might start to matter if liquidity flows turn negative this summer.
It’s been a fantastic year for mega-cap tech stocks, which have defied all the economic gloom to stage a stunning comeback. The risk is that this rally is approaching its ‘finale’ in an environment where valuations are stretched, earnings are stagnant, and liquidity flows are about to turn negative.
Tech party
News flow this year has been quite gloomy. A series of bank failures, a deepening contraction in the manufacturing sector, persistently high inflation, and rising interest rates have been front and center.
Yet, stock markets have been euphoric. The tech-heavy Nasdaq has gained more than 25% so far this year, with Nvidia being the rockstar of this index, having risen 156% on hopes that its graphics cards will power the AI revolution. Meta Platforms is up 119%, Tesla has jumped 82%, and even Apple briefly hit a new record high lately.
Meanwhile, measures of market stress such as the VIX have fallen to their lowest levels in two years. This suggests that demand for downside protection has evaporated, as investors don’t feel the need to hedge so much anymore.
Liquidity pulse
Behind this massive rally lies the incredible force of liquidity injections. Starting in October last year, central banks in Japan and China flooded their financial systems with stimulus, countering the Fed’s quantitative tightening programs.
That was exactly when stock markets bottomed, which is probably not a coincidence. Combined, the Bank of Japan and the People’s Bank of China have injected around $1.3 trillion into their financial systems since October, while the Fed has only reduced its own balance sheet by $300 billion over the same period.
Hence, there was a net-liquidity injection of almost $1 trillion finding its way into global markets. When such a tsunami of money is unleashed, it naturally pushes all boats up. But it’s the riskiest assets that gain most, helping to explain the dramatic outperformance of tech shares, unprofitable companies, and cryptocurrencies.
Built on shaky foundations
It is so difficult to trust this rally because it has not been matched by an increase in corporate profits. Earnings for the entire S&P 500 are essentially stagnant from last year. In the tech sector, earnings are down 8.5% year-on-year, even though this group has spearheaded the advance.
Since profits are flat or falling, all that has happened since the markets bottomed nine months ago is that valuations have gotten more expensive. The S&P 500 currently trades for 18.1 times what analysts think earnings will be over the next year.
That’s expensive from a historical perspective, but it’s almost ridiculous when you consider that earnings are not growing and could even contract in the coming quarters as the economy continues to slow.
Analyst estimates suggest corporate America will return to earnings growth in the third quarter of this year. Alas, that’s exactly when the lagged impact of all the Fed’s rate increases is likely to be felt in the economy, making it seem a little unrealistic.
Liquidity goes into reverse?
Looking ahead, the liquidity impulse that has carried markets higher is likely to go into reverse soon. China and Japan have already started to taper their money printing, while the Fed and ECB continue to drain liquidity via their quantitative tightening programs.
Meanwhile, the US Treasury will need to rebuild its cash balance over the next few months now that the debt ceiling has been lifted. The plan is to raise its cash levels to $600 billion by September, which can reduce bank reserves and remove liquidity from financial markets, depending on who buys all the bonds it issues.
Blending everything together, it seems like the sensational rally in risk assets might be approaching its conclusion. In the short term, a lot will depend on whether the Fed raises rates next week. Overall though, valuations seem excessively optimistic as they are not underpinned by rising earnings, which might start to matter if liquidity flows turn negative this summer.
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