Bubble Check and the Magnificent 7 Strategy

How Bubbly is the Market?

Market bubbles clearly come in many shapes and sizes. Some of the largest bubbles have included the Dutch Tulip Bubble, South Sea Bubble, Nifty Fifty Bubble, Biotech Bubble, Dot Com Bubble, US Housing Bubble, Bitcoin Bubble, and now perhaps an AI Bubble. Some bubbles are quite narrow in scope, while others have a much wider impact. AI simultaneously evokes excitement for the rapid improvement in all aspects of our lives while making us fearful that machines could take over the world as depicted in “The Terminator” film series.

As investors, we need to make hay while the sun shines. This means using rules rather than emotions to profit from the bubble without being hurt if and when it pops. And, that leads to the question, “How Bubbly is the Market?”

The table below shows the 5-month returns just before a set of bubble-ish events. During the 2000 tech bubble the Nasdaq QQQ gained 92% and diverged sharply from SPY, whereas in the last five months, both returned a mere 17.8% and 17.4% respectively. However, the recently launched Magnificent Seven ETF, which tracks breakaway AI stocks, advanced 31% in the last five months, which is unsustainable. Complicating the matter further is that high rates of return are also found following a market bottom. The October 2022 market low and subsequent December 2023 new high are not yet very far back in the rearview mirror. Of course, P/E ratio must also be part of this discussion.

The long-term Nasdaq 100 P/E ratio charted below illustrates that its P/E in normal markets is about 25 and that a P/E of 50 or more is likely in bubble trouble. While a P/E of 35 seems like a long way from trouble, if QQQ continues to rise at the same 17.5% rate through the end of the year and tapped-out consumers reduce spending (and thus corporate earnings) by 15%, its P/E ratio could exceed 50. In an election year with AI exuberance and tapped-out consumer credit cards, it could happen.

In the four months since StormGuard turned on a dime to reflect the strong bullish conviction that the Fed was done raising rates, StormGuard’s four primary components have continued to indicate that the market remains broad and strong with little volatility.

What About the Prophesied Recession?

Recession proponents suggest that the recession has been delayed by a combination of continued excess federal spending and our new obsession with AI. In the chart below, the Sahm Recession Indicator (blue line) signals the start of a recession when the three-month moving average of the national unemployment rate (U3) rises by 0.50 percentage points (red line) or more relative to the minimum of the three-month averages from the previous 12 months. The Federal Funds Interest Rate (green line) is superimposed on the Sahm Recession chart.

The relationship between the green and blue lines suggests that previous recessions did not start until the Fed started aggressively taking down interest rates. But as you recall, economists always speak of a lag time of 12-18 months between interest rate changes and its effects taking root in the economy. Thus, by the time it becomes apparent that higher rates have triggered a recession, it is already 12 months too late to begin taking rates down to prevent it.