Sonders: Beneath the Surface of Market Highs

March 4, 2024

11 minute read

by Liz Ann Sonders, Chief Investment Strategist, Kevin Gordon, Charles Schwab & Company Ltd.

Investor sentiment and stock market valuations are getting increasingly stretched as indexes trek higher, but solid underlying breadth has been a positive offset for now.

As headline stock indexes have marched higher this year (and since the recent October 2023 low) without a serious pullback, investor sentiment has started to look increasingly optimistic and frothy, which we think is a building risk to the market (with caveats mentioned later). Unsurprisingly, those in the trend-following camp have grown increasingly excited as the S&P 500 has taken out its January 2022 high and crossed the 5,000 level.

What the duck

The reality is the stock market is acting a little more like a duck than a bull: calm on the surface but paddling like the dickens underneath (chef's kiss to Michael Caine, who coined that phrase). Check out the performance table below, which is posted on my (Liz Ann's) X feed every morning. Per the third column, the S&P 500 and Nasdaq have suffered no more than a -3% drawdown from a year-to-date high—but that's at the index level. Looking under the surface yields a very different picture. Although not as extreme for the S&P 500, the average Nasdaq member maximum drawdown from year-to-date highs is a whopping -22% (yes, that's a bear-market-level decline).

The Nasdaq has suffered a -3% drawdown from a year-to-date high but the average member maximum drawdown is a whopping -22%.

Source: Charles Schwab, Bloomberg, as of 3/1/2024.

Indexes are unmanaged, do not incur management fees, costs and expenses and cannot be invested in directly. Past performance is no guarantee of future results. Some members excluded from year-to-date return columns given additions to indices were after January 2024.

Glancing at the right half of the table above, you'll see even sharper extremes of churn under the surface. Since the major market lows of October 2022, the S&P 500 is up 44% (far right column), but the index's average member maximum drawdown has been -26% over that same period. In the case of the Nasdaq, those performance numbers are +56% and -54%, respectively.

[There is an important aside with regard to the Nasdaq. Per Leuthold Group research, the number of Nasdaq-traded securities ballooned by nearly 60% (about 2000 new issues) from mid-2020 to mid-2022. Not all of those issues were companies with real operations. Some of them were warrants and others were special purpose acquisition companies (SPACs), which can distort a variety of breadth measures.]

Generals vs. soldiers

We've written and spoken extensively about market breadth. It's unfortunate, with two wars underway, that a battlefront analogy is most illustrative. When it's only a few generals on the front line—even if they're five-star generals—and the soldiers having fallen behind, it's not a strong front. Conversely, even if a general or two falls behind, if more soldiers have moved up, it's a stronger front.

As shown below, this year has been marked—so far—by the S&P 500 marching to an all-time high (top part of chart), yet the percentage of stocks trading above their 200-day moving averages (bottom part of chart) has been flat. The early part of the rally off last October's low was accompanied by a sharply rising share of stocks trading above their moving averages; but that has clearly faded over the past couple of months.

New highs but flat breadth

The S&P 500 is at an all-time high, yet the percentage of stocks trading above their 200-day moving averages has been flat.

Source: Charles Schwab, Bloomberg, as of 3/1/2024.

Indexes are unmanaged, do not incur management fees, costs and expenses and cannot be invested in directly. Past performance is no guarantee of future results.

Another breadth measure—and a trademark of healthy bull markets—is a growing percentage of stocks hitting 52-week highs relative to 52-week lows. As per SentimenTrader data, and shown in the chart below, across the very broad New York Stock Exchange (NYSE), more securities have been recording new highs than lows, which is a stark change from 2022 and even most of last year.

Slow improvement in new highs

Across the very broad NYSE more securities have been recording new highs than lows, a stark change from 2022, and even most of last year.

Source: Charles Schwab, SentimenTrader, as of 3/1/2024.

NYSE (New York Stock Exchange) net high minus low shows the net percentage of NYSE securities trading at a 52-week high minus the percentage trading at a 52-week low. Indexes are unmanaged, do not incur management fees, costs and expenses and cannot be invested in directly. Past performance is no guarantee of future results.

There's a caveat, highlighted in the chart below. So many NYSE issues fell to 52-week lows in 2022—with 2023 not offering a lot of improvement—that the past few months have only made a slight difference in the cumulative new high/new low line. It has started to turn higher, but more work needs to be done here.

Making up lost ground

The NYSE cumulative new high/low line has started to turn higher in 2024.

Source: Charles Schwab, SentimenTrader, as of 3/1/2024.

NYSE (New York Stock Exchange) cumulative new high/new low line takes the daily net number of 52-week highs minus 52-week lows on the NYSE and adds it to the previous day's total (or subtracts it if there were more lows than highs). Indexes are unmanaged, do not incur management fees, costs and expenses and cannot be invested in directly. Past performance is no guarantee of future results.

Notwithstanding some improvement in breadth, as shown below, it's still the case that a historically low percentage of S&P 500 stocks have outperformed the S&P 500 over the past 12 months. This is improving over shorter trailing spans, as shown in the table below the chart. In fact, over the past month, 40% of S&P 500 stocks have outperformed the index. This is improving news, but more soldiers need to continue to advance.

Soldiers not keeping up

A historically low percentage of S&P 500 stocks have outperformed the S&P 500 over the past 12 months.

Source: Charles Schwab, Bloomberg, as of 3/1/2024.

Indexes are unmanaged, do not incur management fees, costs and expenses and cannot be invested in directly. Past performance is no guarantee of future results.

% of S&P 500 members outperforming S&P 500 Index over the past:

A historically low percentage of S&P 500 stocks have outperformed the S&P 500 over the past 12 months. 1m2m3m4m5m6m1y40%31%38%33%31%32%12%

Disclosures

Not as "mag" anymore

The obsession over the so-called "Magnificent 7" (Mag7) group of stocks hasn't abated, but again, under the surface is where the real story is told. The moniker was originally based on capitalization—with the stocks representing the seven largest stocks by market cap in both the S&P 500 and Nasdaq. Interestingly, they are no longer the largest seven stocks, with Tesla having dropped out (and leap-frogged by Berkshire Hathaway and Eli Lilly, with Broadcom closing in as well).

The chart below shows their performance since the beginning of 2023, and what's clearly noticeable is the widening divergence in performance so far in 2024 vs. 2023.

Diverging Mag7

The "Magnificent 7" stocks have exhibited a widening divergence in performance so far in 2024 vs. 2023.

Source: Charles Schwab, Bloomberg, as of 3/1/2024.

Data indexed to 100 (base value=12/30/2022). An index number is a figure reflecting price or quantity compared with a base value. The base value always has an index number of 100. The index number is then expressed as 100 times the ratio to the base value. All corporate names and market data shown above are for illustrative purposes only and are not a recommendation, offer to sell, or a solicitation of an offer to buy any security. Supporting documentation for any claims or statistical information is available upon request. Past performance is no guarantee of future results.

As shown in the right side of the table below, all seven Mag7 stocks were strong performers last year—up double- or triple-digits and ranked within the top 13% of the S&P 500 index. But what a difference the turn of the calendar has made. As shown in the left side of the table, so far this year, the performance ranges from +66% to -18%, with Tesla and Apple having fallen to near the bottom of the performance ranking pack.

All seven Mag7 stocks were strong performers last year but this year the performance ranges from +66% to -18%, with Tesla and Apple having fallen to near the bottom of the performance ranking pack.

Source: Charles Schwab, Bloomberg, as of 3/1/2024.

S&P 500 ranking based on performance within the S&P 500. All corporate names and market data shown above are for illustrative purposes only and are not a recommendation, offer to sell, or a solicitation of an offer to buy any security. Supporting documentation for any claims or statistical information is available upon request. Past performance is no guarantee of future results.

Party like it's 1999?

Lots of comparisons are being made between the dominance of a small handful tech and tech-related stocks driving performance over the past year and the dot-com bubble leading into 2000. We think there are important differences today; not least being less of a "denominator" problem (i.e., an earnings problem or the E in P/E) today relative to the late 1990s, when profits for many companies were (pipe) dreams, not reality.

During the fourth quarter of last year (the books are just closing on its reporting season), top-line growth for the Mag7 was 15% year-over-year. Profit margins were up more than 600 basis points year-over-year, which resulted in year-over-year earnings growth of about 60%. To put that into perspective, the remaining 493 stocks in the S&P 500 actually lost money last quarter, with a year-over-year earnings decline of about 2%.

Valuations are undoubtedly stretched for the Mag7, but they have some of the strongest balance sheets of all U.S. companies, generating gobs of free cash flow. Per Goldman Sachs analysis, the Mag7 reinvests about 60% of that cash flow into capital spending and research/development, which is more than three times what the other 493 companies reinvest.

Yes, the stocks are over-owned and richly valued, but all-or-nothing makes less sense than periodic rebalancing in the interest of keeping concentration risk in your own portfolios at bay. In the meantime, there is a widening array of stocks stealthily performing better this year. We continue to emphasize a factor-oriented approach (screening/investing based on characteristics), with focus on quality-oriented factors like strong free cash flow, ample interest coverage, positive earnings trends, etc.

Everyone's feeling good

Enthusiasm around the Mag7 and other megacap stocks has contributed to a stretched sentiment environment. As shown in the chart below, SentimenTrader's (ST) "Dumb Money Confidence" (DMC) is back in excessive optimism territory and hovering near the upper end of its historical range. That's mostly to be expected, given the DMC crew tends to get most exuberant at market peaks and most dour at market bottoms. Conversely, the "Smart Money Confidence" (SMC) crew usually turns quite bullish at market bottoms and thus moves inversely with the DMC.

Yet, in an odd twist, both confidence indexes have moved higher recently. Per ST, there have only been five prior instances in the DMC and SMC indexes' history when both increased by at least 10% over the prior month and were at or above the 50% threshold (as is the case now). Forward returns in those periods—1999, 2004, 2007, 2013, and 2023—were mixed, especially since two of those years preceded rough bear markets.

Crowd gets confident

Both Dumb Money Confidence and Smart Money Confidence indexes from SentimenTrader have been rising over the past month, which is unusual to see throughout both indexes' histories.

Source: Charles Schwab, SentimenTrader, as of 3/1/2024.

SentimenTrader's Smart Money Confidence and Dumb Money Confidence Indexes are used to see what the "good" market timers are doing with their money compared to what the "bad" market timers are doing and are presented on a scale of 0% to 100%. When the Smart Money Confidence Index is at 100%, it means that those most correct on market direction are 100% confident of a rising market. When it is at 0%, it means good market timers are 0% confident in a rally. The Dumb Money Confidence Index works in the opposite manner.

Corroborating the excitement expressed in DMC has been a move higher in ST's Panic/Euphoria Index, which is based off the version originally created by the late, great Tobias Levkovich at Citi. We like it because it's an amalgamation of sentiment indicators across the attitudinal and behavioral spectrum. As shown below, the index has climbed from its low point at the end of 2022; but fortunately, it isn't anywhere near peak euphoria levels of past cycles.

Excited, but not euphoric

SentimenTrader's Panic/Euphoria Index has climbed nicely from its low point at the end of 2022; but fortunately, it isn't anywhere near the peak euphoria levels of past cycles.

Source: Charles Schwab, SentimenTrader, as of 3/1/2024.

This model is based on the Citi Panic/Euphoria model that is published in Barron's magazine. It does not reflect those published values, rather it is our interpretation of the model inputs and construction, and differs modestly from the published figures. The inputs are the same, however its performance as a contrary indicator is improved over the published values. It is composed of the following primary inputs: NYSE short interest, margin debt, Nasdaq vs NYSE volume, Investor's Intelligence survey, AAII survey, retail money market funds, put/call ratios, commodities prices, and retail gasoline prices. The higher the model, the more investors are in a euphoric mood, with lower expected stock returns going forward. Low values, particularly below zero, suggest that investors have panicked and higher forward returns are expected. Past performance is no guarantee of future results.

The good news is that the index's current level is supportive of sentiment being able to run hotter and the market having more runway ahead. The rub is that certain components within the index have gotten quite stretched and are consistent with increasing levels of frothiness. Flows into equity funds (particularly high-flying areas like the Tech sector) have gotten aggressive, the equity put/call ratio is hovering near the lower end of its historical range, and the American Association of Individual Investors (AAII) bull/bear spread is quite high, among others.

Pay up

Tying this all together, it's worth noting that the market has gotten more expensive as sentiment has grown more exuberant. Shown in the chart below is the five-year normalized price-to-earnings (P/E) ratio for the S&P 500. This comes from our friends at The Leuthold Group and uses four-and-a-half years of trailing earnings data, combined with two quarters of forward estimates to get a smoothed "E" component in the P/E.

With the market having surpassed its January 2022 high, we can now definitively say that the October 2022 low for the S&P 500 was the most expensive trough in history (shown via the far-right yellow dot in the chart). It didn't take long in the market's run since last October to get back to the expensive end of this P/E's historical range. However, like the Panic/Euphoria Index, it's not yet back to extremes seen in prior cycle peaks.

Valuation rich but not extreme

The S&P 500's 5-year normalized P/E ratio has increased to the more expensive end of its historical range.

Source: Charles Schwab, The Leuthold Group, as of 2/23/2024.

Normalized P/E uses five-year average earnings (18 quarters of historical results combined with two quarters of future estimates). Indexes are unmanaged, do not incur management fees, costs and expenses and cannot be invested in directly. Past performance is no guarantee of future results.

This gets to two important points we like to emphasize whenever talking about valuation and sentiment. First, we like to think of valuation as a sentiment indicator; or better yet, an indicator of sentiment. There have been times—like in early 2009 and during most of the 1970s—when investors weren't willing to pay anything for stocks. There have also been times—like in the late 1990s and throughout 2021—when investors were willing to accept nosebleed valuations. Today, we're getting closer to the latter environment.

Second, and related to the earlier points made about sentiment, frothy sentiment in and of itself is not a contrarian market timing tool (and vice-versa in times of pessimism). It is true that for many sentiment metrics, the current zone of optimism tends to be consistent with weak forward equity returns; however, a negative catalyst is typically needed to push stocks in the other direction. This could come in the form of surprises in economic and/or inflation data, adjustments in the outlook for Federal Reserve policy, or a breakdown in the market's underlying breadth.

In the meantime…

Investor sentiment and valuation are stretched, but there have been some signs of improving market breadth. With indexes like the S&P 500 and Nasdaq trading at/near all-time highs, but with lots of churn under the surface, investors should be mindful of concentration risk within their own portfolios. Periodic (and portfolio-based) rebalancing can help alleviate that concentration risk and stay in gear with the market via "adding low and trimming high." For those investors looking for opportunity amid the churn, we recommend staying up in quality and using a factor-oriented approach.