Reasons to remain cautious on Stocks

Bond volatility, surging interest rates, and resilient economies suggest investors should be made aware of the potential risk the market bears for the moment.

A number of companies show a year-to-date performance of nearly 100% and the market either doesn’t appear to worry about the earnings outlook for 2024; in fact, given the present reacceleration in growth, the market participants believe that both later next year and 2025 will show a positive earnings growth. For sure, these investors might argue that the higher valuations are anticipating the Central Banks to cut interest rates massively with the aim to re-accelerate the economy. Yet, the bond market doesn’t seem to agree with that conclusion, given the recent rise in yields. As of now, the price-earnings ratio for the S&P 500 is up approximately 15%, and with interest rates up this year, the equity risk premium has collapsed by 100 basis points to its lowest level since the tech bubble era!

There are some more disconnects. Manufacturing indices from the Institute for Supply Management (ISM), which look at manufacturing-sector activity and have historically been a strong indicator of the overall direction of the economy, have been sliding for 18 months and have been in contraction territory for the last eight of those. Given this, the world’s leading economic center may run into a soft landing and an earnings recession.

Another market indicator to look at is liquidity. In recent weeks, market liquidity has been fading – the recent break-out, above the psychologically important 4% level, of nominal ten-year yields might be taken as evidence of an oncoming market correction as neither higher interest rate levels nor volatility are generally conducive to higher equity valuations.

While summer is the time to enjoy fireworks, we aren’t expecting this to happen in the stock market. With growth expectations higher than 6-months ago, markets have become more vulnerable. We suspect that for many earnings reports the main driver will be “sell the news” , irrelevant to what the company post is going to be since the market begins to look ahead on how the entity might disappoint in the future.

How to invest:

Investors should beware of the bust that follows the boom. Since the question of when this will occur can’t be solved, we conclude to invest in a well-diversified selection of stocks that benefit from secular growth, be in Energy Transition, Electric Vehicles, Semiconductors, and top-line Luxury. To help reduce the volatility of the portfolio, we consider investing in longer-maturity investment-grade bonds.