Bubble Check and the Magnificent 7 Strategy

businessman with charts graphic

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.

5 Month Returns from Bubble Events

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.

long-term Nasdaq 100 P/E ratio chart

Famed investor Ray Dalio recently posted an article entitled “Are We in a Stock Market Bubble?”, which has a quite thorough explanation of the six factors that go into his Equity Market Bubble Gauge chart (below). He answers the article’s question this way: “When I look at the US stock market using these criteria, it—and even some of the parts that have rallied the most and gotten media attention—doesn’t look very bubbly.” While in 2021 it was a bit bubbly following the COVID rebound, the 2022 market downturn neutralized the problem. However, dreams of AI growth are now wrestling for dominance with a long overdue recession.

USA Equity Market Bubble Gauge

Where the Market is Headed

The market continues its steady climb to ever-higher highs. However, it remains bifurcated into the moderate performance of the majority of stocks and the anointed Magnificent Seven AI darlings that are somewhat reminiscent but not quite as pronounced as the Tech Bubble 24 years ago. Despite continuing recession warnings from multiple technical indicators that investment professionals rely on, the allure of near-tern returns particularly from emergent AI technologies continues to outweigh recession fears.

The Fed has strongly pushed back on the excess optimism of the media and investors with its “higher for longer mantra.” Recent new economic data and past monthly corrections have not been significant enough to render a conclusion other than “its still about the same as last month.”

SPDR S&P 500 ETF - 6 Months

6 Months

SPDR S&P 500 ETF SPY - 6 Years

6 Years

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.

StormGuard Four Primary Components

Bumps Ahead – Expected

Traders monitor news feeds for actionable trades that typically result in price movements that are transient on the scale of days, weeks, months, or longer. A few percent price volatility is normal background noise, but larger-scale events do occur. Market drops of over 5% begin to scare investors into selling and locking losses. Its best to let StormGuard judge When to Get Out of Dodge.

Declines in the S&P 500 since 12-31-1945

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.

Can we avoid the pending recession? Will it different this time?

Recession indicator vs federal funds rate

Own the Bubble Magnificent Seven DD

This momentum strategy is composed of the Magnificent Seven stocks and employs our Dual Defense and Low-Noise Momentum to “Own the Bubble.”

You can import this strategy into your account by creating a new Strategy, clicking its blue “S” icon, and searching the list of posted Strategies for “Magnificent,” selecting it and clicking the Use Selected button. Alternatively, from the same popup, insert the below ID into the upper-right text box. Click to import it.

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Magnificent 7 Dual Defense

Magnificent Seven Dual Defense
(click to enlarge)

Scott Juds

Patience, not panic! Rules, not emotion!
May the markets be with us,

Scott Juds
Chairman & CEO, SumGrowth, Inc.

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Investing involves risk. Principal loss is possible. A momentum strategy is not a guarantee of future performance. Nothing contained within this newsletter should be construed as an offer to sell or the solicitation of an offer to buy any security. Technical analysis and commentary are for general information only and do not constitute a personal recommendation or take into account the particular investment objectives, financial situations, or needs of any individual. Before investing, carefully consider a fund’s investment objectives, risks, charges, and expenses, and possibly seek professional advice. Obtain a prospectus containing this and other important fund information and read it carefully. SumGrowth, Inc. is a Signal Provider for its SectorSurfer and AlphaDroid subscription services and is an Index Provider for funds sponsored by others. SumGrowth, Inc. provides no personalized financial investment advice specific to anyone’s life situation and is not a registered investment advisor. See additional disclaimers HERE.