Is the Rally a Bubble?  Can it Pop?

Michael Normyle – Nasdaq’s US Economist joins IBKR’s Jeff Praissman to discuss the “Magnificent Seven”, the market rally, this earnings cycle, and if we are experiencing a bubble.

Summary – IBKR Podcasts Ep. 147

The following is a summary of a live audio recording and may contain errors in spelling or grammar. Although IBKR has edited for clarity no material changes have been made.

Jeff Praissman 

Hi everyone. Welcome to IBKR podcasts. I’m your host, Jeff Praissman. It’s my pleasure to welcome back to the IBKR podcast studio, Michael Normyle, NASDAQ’s US economist. Welcome Michael, how are you doing? 

Michael Normyle 

Doing well, thanks for having me back. 

Jeff Praissman 

Always our pleasure to have you back in the studio. We appreciate you coming in once a month for our podcast on the economy.  

Today I want to talk about something that all our listeners are obviously very into, following IBKR podcasts, the market.  

S&P 500 is trading at record highs and there’s been a lot of talk in the news, both print and TV, everywhere you go, you hear about this Magnificent Seven. And the effect they are having on the S&P 500. Let’s start with what stocks make up famous Magnificent Seven. 

Michael Normyle 

Well, yeah. So the Magnificent Seven, it’s all stocks that now or at one point had a market cap of at least $1 trillion. And of course I have to mention they’re all listed on NASDAQ. So those are Alphabet, Google’s parent company, Amazon, Apple, Meta, Microsoft, NVIDIA and Tesla. 

Jeff Praissman 

So really household names, when it comes down to it, I mean, not only are they super successful companies and high valuations, but certainly pretty much everyone’s heard of those companies.  

With the S&P trading these record highs, is it only these seven stocks that are up? Or the rising tide lifting all or many of the boats? Are many stocks up, just they’re not in the limelight? 

Michael Normyle 

Yeah, well, we’ve seen this rally kind of going back to late 2022. And over that time frame, the Magnificent Seven as a group has seen their share price roughly double. But the rally is broader than that. So the NASDAQ 100 is up about 70%, S&P 500 is up around 35%. Then the DOW is up around 20%.  

If you look at NASDAQ’s Mid-Caps, the QQQJ, that’s up about 20%. Small-Caps, the QQQS, that’s up about 5%. I think it’s important to remember that this rally that we’ve seen, it’s coming off a bear market that we saw when the Fed pivoted to rate hikes early in 2022.  

So you can kind of look at this rally in a few different pieces. So from its start to last October, then the last couple months of last year and this year. And so from the beginning of the rally till the end of October, when 10-Year Treasury yields peaked at 5%, the rally was really driven a lot by these Magnificent Seven stocks and a lot of that had to do with these companies being expected to benefit from artificial intelligence or AI.  

But the last couple of months of the year, we saw a broad-based rally as yields fell and Fed rate cut expectations for 2024 rose. And then this year we’ve seen another return to Large-Caps kind of leading the way as markets dialed back their Fed rate cut expectations.  

Markets are now in line with the Fed plan of 75 basis points and rate cuts this year, which the Fed just reaffirmed at their March meeting. And so in part, that’s because smaller companies are more rate sensitive. Data shows nearly 40% of Small-Cap debt is floating rate compared to 6% for large caps. So the downshift and rate cut expectations is is more of a headwind for Small-Caps. 

Jeff Praissman 

So that kind of leads me to my next question. You definitely answered part of it, at least as far as what’s driving these valuations.  

So it seems like it may have kicked off with sort of that artificial intelligence effect, but now is it fair to say it’s more drifted into actual fundamentals for these rising stocks? 

Michael Normyle 

Yeah. So if we look at the 12 Month Forward PEs for the Mag Seven, again as a group, they were around, it was around 23 at the end of at the end of 2022.  

So investors were paying $23 per dollar of earnings. By last July that had gotten as high as $35. But since November it’s really been hovering around $30, so about 33% higher valuation than we saw at the end of 2022. And the reason for that kind of switch back with valuations coming lower is because earnings are actually up almost 100% for the Mag Seven since the end of 2022. So like you’re saying, it is a lot of fundamentals here. And there is some of course AI optimism.  

And in reality if you think that the bulk of gains from AI is probably a few years out, at least, then that’s why these valuations might be getting ahead of earnings a little bit. But these companies, they’ve seen strong profits and they’ve got real earnings. So the earnings piece of the calculation has increased.  

And then to top that off, the Macro picture has improved, which helps too. So, consider where the economy was at the end of 2022, a lot of people were expecting a recession. Since then the economy has proven much more resilient, so there’s less downside risk to earnings there, too. 

Jeff Praissman 

And with any stock rise, you hear bubble talk, right? There’s talk like are we in a bubble? Are we not in a bubble? Clearly saying that there’s fundamentals behind these tends for me to think that we might not be, but you never know. But what’s your opinion on that? 

Michael Normyle 

Right. Yeah, I don’t think that we are currently, at least. Things can always change, right? But not right now for a few reasons. I think of a bubble as “irrational exuberance”, to borrow a phrase and we’re not seeing that now.  

So if you look at the late 90s, early 2000s Dotcom tech bubble, you saw a rally for a lot of unprofitable tech companies that weren’t able to ultimately deliver those profits that investors had priced in. And so, the bubble eventually burst.  

Right now, though, if you look at the non-profitable companies, they haven’t been a part of this rally so much. And then even recently we’re seeing returns diverged for the Mag Seven companies since late last year, so it’s not just blind speculation where this group as a whole is just rising.  

And then even surveys that the American Association of Individual Investors (AAII) does shows only 47% call themselves bullish right now, compared to 75% in 2000. And even 60% in early 2018. So there’s some kind of caution from investors.  

And then the rally has gotten less top heavy with the equal weight S&P 500 hitting a record high. And then, again, getting back to the valuations, the NASDAQ composite PE, it’s under 30 right now, that’s below the 35 level it reached in late 2020, as we were kind of in the rally from the pandemic. So valuations aren’t even as stretched as we saw back then. And again that’s because we’ve seen those earnings rising. So NASDAQ composite earnings were up 30% since the end of 2022, compared to an 18% increase in PE, so that’s where rising earnings are kind of justifying what we’ve seen. 

Jeff Praissman 

So really, even though the tech companies are in the limelight and the spotlight and kind of leading the charge, we both agree that we’re not in a bubble.  

And it was great that you brought up the infamous tech bubble of the 90s, right? Where like, everything with a Dotcom was the most valuable company in the world. I mean, you had that sock puppet thing, you had whatever company that was out there that had a .com at the end of their name, whether they’re on the Internet or not, seemed to just explode in value.  

So certainly very different today than back then. And besides for those seven, you sort of touched on this, how are stocks doing? Is everyone beating earnings or is it like mixed and matched or are certain industries faring better than others?  

We touched on the election last time, so obviously that might have some effects on it as well. 

Michael Normyle 

With regard to earnings, what we saw in Q4 in particular was with Large-Caps that it was pretty broad-based and that earnings Large-Caps, as a whole, did well.  

We saw at the start of Earnings Season, expectations were that they would contract 2% year over year for the S&P 500. But by the end of Earnings Season, they were up 4% year over year. And so it helped kind of push Large-Caps up with the earnings results turning out so well.  

And like I said, it was pretty broad-based, but the kind of weakness that we had seen in healthcare from the drop in COVID spending, in energy from energy prices coming down from a year earlier, materials as well, which had some headwinds from the weakness that we’ve seen in manufacturing lately, those are kind of the weak areas that we saw.  

But more broadly, most sectors did quite well. But if you’re looking at Mid-Caps, for example, S&P 400 Mid-Caps, they exited their earnings recession in Q4. With earnings growing over 2.5%. But Small-Caps, they’re still on an earnings recession, falling almost 25% year over year in Q4 and contracting for the sixth straight quarter. So it really depends on if you’re looking at Large-Caps, Mid-Caps and Small-Caps. 

Jeff Praissman 

I want to pivot a little bit. We started this conversation off talking about the S&P 500, which everyone knows. I really like the fact that you brought in other benchmarks into the conversation. Not just US benchmarks, but also global benchmarks.  

Listen, we’re in a global world more so now than ever. The other US and the foreign benchmarks, they seem to be experiencing record highs as well, really, right? Is that a  correct statement? 

Michael Normyle 

Yeah, exactly. So especially for Large-Caps, right? The NASDAQ composite, S&P 500, even the equal weight S&P 500, as I mentioned earlier, they’re all at record highs. The Dow, too. 

And then in Europe, the stocks hit 600. Hit a record high. In Japan, the Nikkei hit a record high. And for the US and Europe, there could be some potential tailwind from expectations of rate cuts this year from their central banks.  

That’s not the case in Japan, of course, with Bank of Japan just exiting their negative rates policy. But it has been kind of a global experience in a lot of ways. 

Jeff Praissman 

It may be a really good question, just so our listeners get the perspective.  

Compared to the other global benchmarks, like say FTSE or DAX, what percentage does the US make up? 

Michael Normyle 

Well, so according to UBS, US equities are about 60% of global equities based on the FTSE Russell All-World Index.  

In comparison, UK is about 4% and Germany is about 2%. Of course, as this whole discussion started, we’re also home to many of the largest companies in the world. And many of them have large, international footprints, too. So of course.  

And then to top it off, the US is the largest economy in the world. So the outsized role that the US plays in global equities makes a little more sense when you consider the global context of these companies that are based in the US, too. 

Jeff Praissman 

Right. So even though they’re based in the US, foreign countries are benefiting from the foreign countries.  

So like we kind of stated earlier, it really is a global economy more so than ever these days. Any other thoughts you want to leave our listeners with as far as just sort of the current economic situation or the way the stock market’s going? 

Michael Normyle 

Yeah, I think just in terms of the whole bubble discussion, we’re going to have to worry about a bubble when we don’t see earnings supporting the returns we’re seeing anymore. whether that’s prices getting so far ahead of earnings growth or earnings actually falling.  

For now, though, with the soft landing looking more and more likely, the Fed expected to start easing up on rates, it looks like we’re in a good spot, in my opinion. 

Jeff Praissman 

Michael, this was great.  

I mean, thank you again for coming by and joining us at the IBKR podcast studio.  

For more from Michael on NASDAQ, just please go to our website under Education. You can view previous NASDAQ webinars, as well as our previous podcast with Michael. You can click on contributors, or you can click on the podcasts, and you can find him. Thank you again for listening.  

Until next time, I’m Jeff Praissman with Interactive Brokers.