In the war between the bulls and the bears, the bulls just won a key battle…
As of Tuesday, the S&P 500 is up 20% from its October 2022 low. That means we’re in a new bull market.
And it likely comes as a surprise to many… including myself.
Three months ago, a regional banking crisis threatened to destabilize the entire U.S. financial system…
The Federal Reserve had gone on its most aggressive rate-hike cycle in 40 years…
And consumer spending had fallen for two straight months.
Then, already by April the storm clouds started to clear…
In our May 24 issue, we told you the economy has been holding up remarkably well despite rising interest rates, persistent inflation, and fears of a banking collapse.
While we’re more encouraged by the recent action than we were three months ago… We remain cautious. The headwinds we highlighted above are still present.
However, as we’ll explain in today’s issue, the data tells us that stocks could potentially “melt up” in the near term.
A melt-up is when the market suddenly explodes higher – and FOMO (fear of missing out) starts to rear its ugly head.
So while we remain cautious, we realize there is still money to be made in this market.
Three Reasons We Might See a Melt-Up
There are three trends at work you need to know about: increased corporate earnings, discounted valuations, and positive investor sentiment.
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Improving Corporate Earnings
Heading into the first quarter of the 2023 earnings season in April, Wall Street was trimming its earnings per share (EPS) estimates for the S&P 500.
By the end of March, those estimates fell by 6% over the previous three months.
Since then, they’ve turned higher.
Wall Street is now penciling in a $229.02 EPS over the next 12 months. That’s a 3% rise from its low in March.
We can attribute much of that growth to mega-cap technology companies like Nvidia, Microsoft, and Alphabet. They’ve seen a sharp rise in estimates as investors pile onto the artificial intelligence (AI) bandwagon.
For example, the Global X Artificial Intelligence & Technology ETF (AIQ) is up 37% since January. And Nvidia has exploded 178% over the same period.
However, the earnings turnaround is more broad-based than just AI-related tech stocks.
The S&P 500 has 11 market sectors, including technology. When equally weighted, their EPS estimates have risen by 1.5% since April began.
These earnings results are one clear sign that the market can continue rising.
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Discounted Valuations
Mega-cap technology stocks have seen their valuations rise to near all-time highs amid the AI hype.
They’ve helped push the S&P 500’s current forward price-to-earnings (P/E) valuation to 19x – a level we haven’t seen since the first half of 2022.
However, the S&P 500 is a market-cap weighted index. That means the valuations of Apple, Microsoft, Google, Amazon, and Nvidia contribute to nearly 24% of that 19x multiple.
When you strip out those mega caps, the picture looks different. The chart below shows the market’s valuation when we weigh the 505 stocks that make up the index equally.
From this perspective, the S&P 500 is trading at an 8% discount to its long-term average P/E of 17.1x.
That means the average company is far from overvalued. It’s also a signal that there is plenty of value left in certain stocks.
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Fear of Missing Out
In May, we also highlighted the lack of bullish positioning among individual investors, as measured by the AAII Index. It’s historically a bullish signal.
Since then, we’ve seen the AAII Bullish Sentiment Index experience one of its largest weekly jumps ever. It’s up 15 points since June 1.
The last time it saw a jump this high was in November 2020. The S&P 500 subsequently rose 35% to its January 2021 peak following that jump.
This is another clear sign of FOMO.
That’s backed up by last week’s National Association of Active Investment Managers poll.
According to the poll, investment managers have increased their exposure to equity markets at the fastest pace in more than two years.
Since the 2008 Financial Crisis, there have been six instances when the AAII Bullish Sentiment Index jumped by over 15% in one week.
In five of those six instances, the S&P 500 rose over the subsequent three months. On average, the index continued to rise by another 7.2% across those six instances.
This is another sign that a potential melt-up might be in the offing.
All of that said, let me tell you why we still remain cautious…
The Reason We Remain Cautious
The market might be poised for a melt-up in the short term… But there are still headwinds that can trip up the recent rally.
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The labor market is still strong.
The number of available jobs in the U.S. climbed back to over 10 million by the end of April. Meanwhile the number of Americans collecting unemployment benefits has fallen from 1.86 million on April 7 to 1.75 million as of May 26.
This is an issue because a strong labor market will continue to put pressure on wages to rise. That will give consumers more spending power, exacerbating inflation.
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In addition, while the inflation rate has decreased, it’s still far too high.
The Fed’s preferred measure of inflation – the Core Personal Consumption Expenditures Price Index – has stood still at a 4.7% growth rate since November. That’s well above the Fed’s 2% target rate.
And yesterday morning we got May Consumer Price Index (CPI) figures that have yet to show signs of meaningful slowing.
While much of the attention will be on the drop to 4% year-over-year growth, that’s largely a result of lower oil prices.
Core CPI, which strips out volatile food and energy prices, came in higher than economist expectations at 5.3%, significantly higher than the Fed would like it.
A strong job market and persistent inflation mean the pressure remains on the Fed to either continue raising interest rates or – at the very least – keep interest rates higher for longer than the market is anticipating.
We won’t have to wait long to learn more about what the Fed is planning. It’s meeting today and will announce its next move at 2 p.m. ET.
Investors have placed a 70% probability that the Fed will hold off on raising interest rates. Even if investors are correct, Fed boss Jay Powell is surely going to keep the door open for more hikes.
How to Play a Potential Melt-Up
It’s anyone’s guess what the market will decide to do based on Powell’s statements… So we won’t even try.
But if you’re looking for a conservative way to position yourself for a melt-up, consider generating income by selling put options on high-quality companies in defensive sectors of the market. These include consumer staples, health care, and utilities.
[Put options allow you to generate hundreds or even thousands of dollars quickly without buying a single stock.
Even better… Elevated volatility increases the premiums you can earn on put options.
That means you can earn higher returns and put less of your capital at risk.]
Defensive sectors often show resiliency during economic downturns. Plus, they’ve lagged the overall market this year, so they offer a better value than their high-flying counterparts in technology.
If the market melts up, these stocks will likely see a boost in price. If the economic data darkens, their downside risk is lower since they’re already closer to discounted for that scenario.
If you’re considering selling put options, I strongly advise you set aside enough cash in your account in the event you’ll have to purchase shares. This will occur if the stocks are trading below the strike price on the day the options expire.
And make sure you sell puts on stocks you already would love to own. If they fall in price, you’ll get them at a discount.
And since most of the companies in these sectors pay dividends, you’ll generate income while waiting for the market to turn.
Regards,
Michael Gross
Analyst, Palm Beach Daily