Investors should beware another false dawn

When the S&P 500 index closed above 4,292 on 8 June, it cleared a significant hurdle. It might look like an arbitrary number, but it marks the point at which the US benchmark can plausibly claim to have put last year’s stock market slump behind it. This was the moment when the US’s blue chips had risen by 20pc from last October’s low point of 3,577, and by doing so had met the traditional definition of a bull market.

The measurement of bull markets is more art than science. On plenty of occasions, markets have enjoyed a rally of 20pc or more before reverting to their previous downward path. The stock market bear is a wily beast and enjoys pulling wishful thinkers into its embrace with this kind of sucker’s rally. This time around there are more reasons than ever to question whether this is the start of a sustainable bull market or another false dawn.

The most important of these is the lack of breadth in the last six months’ recovery. The S&P 500 may have risen by 13pc since the beginning of the year but almost all of that gain can be attributed to the performance of a handful of the index’s biggest companies, almost exclusively technology stocks which have soared on the back of investors’ new-found enthusiasm for all things artificial intelligence (AI).

The S&P 500 is market capitalisation-weighted, which means that the larger a company is the more influence it has on the overall level of the index. It is a reasonable way of looking at the market but at times like these, when there is a big divergence between the performance of large and smaller companies, and the leadership is so narrowly focused, it can also be misleading.

Another way of looking at the index is to give each company in it an equal weight. If you do this, the performance of the five largest companies in the index (Apple, Microsoft, Amazon, Nvidia and Alphabet) is no more influential than that of the smallest constituents (Advance Auto Parts, Lincoln National, Newell Brands, News Corp and Dish Network). 

Look at the US market through this equal-weighted lens and the performance year to date is not 13pc but just 3pc. Since the low point on 12 October 2022, the equal-weighted index has risen not by 21pc but 14pc. Impressive, but still a way short of that traditional bull market definition.

So, as the headline index, but not the wider market, moves into bull market territory, investors face two key questions. First, is the recovery since October the real McCoy or just another bear market rally? Second, if we are at the start of a sustainable bull market, what is the best way of playing it?

To answer the first question, you will need to address three subsidiaries: what’s happening to corporate earnings; where next for interest rates; and is the rally broadening out from those AI-focused tech stocks? 

The earnings picture is slowly turning more positive. Not so long ago, the expectation was that the economy was heading towards a recession. And that, historically, has led to a double-digit decline in earnings. Today, the consensus is for a much more modest fall in profits, perhaps only 4pc in 2023. Better still, next year is expected to deliver an earnings rebound of as much as 10pc.

At the start of the year, only around a quarter of companies were seeing an improvement in their earnings forecasts. Today, half of them are. Less bad is the first stop on the journey to 
good and this so-called second derivative is clearly heading in the right direction.
The interest rate question also looks to have a broadly positive answer. This week’s improvement in the US inflation picture gave the Fed cover to put its monetary tightening program on hold. And while next month might have one more hike in store, that is likely to be it for this cycle. With rates likely to peak at 5.5pc in July, the gap between inflation expectations and the cost of borrowing is historically wide. Central banks tend to stop when they have reached today’s level of positive real, inflation-adjusted interest rates.

The third question, on the breadth of the recovery, is the clue to how best to play the next phase of the cycle. For the bull market to be really sustainable it will need to broaden out from the tech stock leadership that has been the defining characteristic of the past six months. And there are early signs that this is happening. 

An index of stocks that retail investors favour, monitored by Goldman Sachs, is breaking out from its recent sideways trading channel. At the same time, more investors questioned by the American Association of Individual Investors are positive on the market’s prospects than are negative, a reversal of the recent trend. 

One last hurdle remains. Typically, bear market rallies run out of steam at or below the point where they have retraced 50pc of their most recent fall. A rally that breaks through this barrier usually goes on to become a sustainable bull market. Here the evidence is mixed. The S&P 500 index has clawed back 63pc of what it lost in 2022. But the equal weighted index is only 39pc of the way there. 

That suggests one of two things. Either this is a bear market rally that has overstayed its welcome and the technology leaders might be hardest hit in the correction. Or the bull really does have legs, and the rest of the market has some catching up to do. 

Tom Stevenson is an investment director at Fidelity International. The views are his own.