Tesla electric cars are stationed in a storage area in the Zeebrugge port, northern Belgium, on June 21. Tesla reported a hefty drop in second-quarter profits due to the effect of price cuts while spending aggressively on artificial intelligence and other technology.JOHN THYS/Getty Images
Investors are beginning to wonder if they have turned into Wile E. Coyote. Like the cartoon character, they are suspended in mid-air, legs churning frantically. Maybe things will turn out all right. But if not, investors have an awfully long way to fall.
The most immediate reason to worry are a couple of problematic earnings reports this week from Tesla Inc. TSLA-Q and Alphabet Inc., GOOGL-Q two of the Magnificent Seven stocks that have powered the U.S. market higher in recent years. Both those high-profile stocks fell on Wednesday, dragging the benchmark S&P 500 Index to its worst day in 19 months.
Stocks regained some of their lost ground later in the week, but jitters remain. Like Wile E. Coyote, the soaring U.S. stock market may be starting to feel the tug of gravity.
It’s not that the Magnificent Seven have suddenly turned into bad businesses. It’s more a matter of whether any company can live up to the exalted expectations that the market has built up around this handful of great enterprises.
Nvidia Corp., the most magnificent of them all, now trades for an awe-inspiring 67 times earnings, roughly three times the average price-to-earnings (P/E) ratio for the market as a whole. Amazon.com Inc. AMZN-Q, Apple Inc. AAPL-Q, Microsoft Corp. MSFT-Q and Tesla also boast nose-bleed valuations. Even the two relative bargains in the Magnificent Seven – Alphabet Inc. and Meta Platforms Inc. META-Q – trade at P/E ratios substantially above the rest of the market.
Optimists will tell you these lofty valuations aren’t necessarily a problem. “Admittedly, equity valuations are, in aggregate, starting to look a little stretched in relation to other assets,” writes John Higgins, chief market economist at Capital Economics. However, he argues that stock valuations could surge even higher since they are still not at the manic levels reached in the dot-com bubble of the late 1990s. He sees the S&P 500 rising from its current level around 5,500 and hitting 7,000 by the end of 2025.
Other observers take comfort in the possibility that investors will decide to rotate away from the Magnificent Seven and into smaller, cheaper stocks. These optimists argue that falling U.S. inflation will prompt the Federal Reserve to start slashing interest rates and that small-cap stocks will be the main beneficiaries of lower rates.
That is certainly possible. Since July 11, when government statistics revealed that U.S. consumer inflation took a surprising dip in June, small-cap stocks have gone on a modest tear. The Russell 2000 Index, a benchmark of small-cap U.S. stocks, has gained more than 10 per cent in just a couple of weeks. In contrast, the S&P 500 Index of big U.S. stocks has slightly declined over the same period.
If this market rotation continues, small-cap stocks may finally get their day in the limelight. Still, it’s hard to see how the overall stock market can do well if the Magnificent Seven stocks encounter any bumps at all. In contrast to Capital Economics’ ebullience, Citigroup analysts see U.S. stocks inching up a mere 3 per cent over the coming 12 months.
Risks are rising. The most obvious uncertainty is the U.S. presidential election in November. A victory by Donald Trump could see Washington jolt the global economy by imposing tariffs on most things the United States imports.
Exactly how these tariffs would work is unclear, but they would probably not be good news for an economy that is already slowing down. “U.S. economic surprises have been persistently negative over the past three months,” notes Eric Lascelles, chief economist at RBC Global Asset Management. Activity indexes for June compiled by the Institute for Supply Management (ISM) are now at levels consistent with a modest contraction in the U.S. manufacturing and services sectors.
To be sure, investors can see what they choose in the current crop of numbers. For all the dismal ISM results, the U.S. economy grew at a robust 2.8-per-cent annualized clip in the second quarter, according to data published this week.
However, forward-looking numbers aren’t so positive. Policy wonks are keeping a close eye on the Sahm rule, an indicator devised by macroeconomist Claudia Sahm to quickly recognize when a U.S. recession is starting.
The Sahm rule looks at the three-month moving average of the U.S. unemployment rate. If that average rises more than 0.5 percentage points above its lowest level over the past 12 months, a recession typically follows.
The Sahm rule has accurately recognized recessions in their early stages since the 1970s and right now it is very, very close to being triggered. The three-month moving average of the unemployment rate has risen 0.43 percentage points from its lows of the past year, just a hair short of the 0.5 threshold.
What should investors do? One thought is to veer away from U.S. stocks, in favour of cheaper Canadian, Japanese and European equities. Another is to bet on the small-cap revival continuing. But maybe the best advice is simply to be cautious and make sure you aren’t taking more risk than you want. As any Wile E. Coyote fan will tell you, chasing a fast-moving target off a cliff does not end well.