When, in early August, stock markets dropped sharply, the Jeremiahs could hardly contain their excitement. At last, they were being vindicated! Wall Street had risen 50% in two years but they had always argued that this defied economic reality. A bear market would provide them with the investment opportunity at much lower prices they had long been waiting for. Three factors were cited to explain the fall in markets.
Americans seized on some disappointing domestic data to argue that the economy was not merely slowing but heading for recession. The technology-phobic British preferred to focus on a setback to the “Magnificent Seven” tech-focused US stocks. These had jointly risen 120% since the start of the bull market in October 2022, three times the jump of the rest of the S&P 500, but fell 18% in the four weeks to 7 August, led by a 27% fall for Nvidia. Others pointed to a 10% jump in the value of the yen from historic lows, arguing that this caused a collapse in the carry trade. Investors had, supposedly, borrowed in yen at very low interest rates and converted the proceeds into dollars to invest in Wall Street, benefiting both from the bull market in the S&P 500 and a falling yen.
None of these explanations stood up to scrutiny. Subsequent economic data, notably US retail sales and unemployment claims, did not support the forecast of an imminent recession. Corporate earnings collectively showed no signs of even flinching. Anyway, with inflation low and falling, there was always ample scope for the US Federal Reserve to cut interest rates, with the benchmark federal funds rate at a 23-year high of 5.25%-5.5%. This would have been positive both for GDP and markets.
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The investment opportunities
The tech-phobics were cheering the “collapse of the bubble” in the Magnificent Seven. But the best definition of a bubble is “a bull market you’re not invested in”. At the end of July, Ed Yardeni of Yardeni Research estimated that the Magnificent Seven plus Netflix were trading on 30 times forward earnings, a 44% premium to the 20.6 for the S&P 500 as a whole and a 62% premium to the remaining 492 S&P stocks. Yet while the S&P 500’s earnings are growing at an annualised rate of 10%-12%, those of the Magnificent Seven have been growing more than twice as fast. Their valuations may have run ahead of earnings, and quarterly earnings reports will disappoint from time to time, but that justifies a setback, not a collapse.
If investors were borrowing yen to buy the US market, it’s surprising that the 17% peak-to-trough fall in the Japanese market was more than twice that of the US market, though the fall in dollar terms was much less. That the Japanese yen was massively undervalued was universal knowledge, so anyone speculating on a further fall was pretty stupid, suggesting that the “carry trade” was small in scale. There have been no reports of big losses yet. Yardeni forecasts total forward earnings for the S&P 500 of $275 per share at the end of this year, $300 next and $325 for 2026. A forward multiple of 20 would imply an index level of 6,500 at the end of 2026, while a more cautious multiple of 18 implies 5,850. The current (recovered) level of 5,687 therefore requires not just sustained earnings growth but also the continuation of an elevated multiple of earnings.
What could go wrong? Endemic inflation could propel the yield on US Treasury bonds, now 3.9%, higher. If this caused the Fed to raise interest rates further, a recession could ensue, corporate earnings would fall and a proper bear market would follow. US small and mid-caps and non-US markets might be protected by lower valuations but, as August showed, that is not what usually happens. When Wall Street sneezes, the rest of the world catches a cold.
Worries that unsustainable government deficits will eventually spook bond markets, pushing yields higher, are legitimate but that has not been the experience of Japan. As Yardeni reports, “revenues in the US are rising faster than expected, helping to bring the 12-month budget deficit down from $2.3 trillion a year ago to $1.6 trillion”. He adds that “outlays remain on an unsustainable course, led by record net interest outlays”, but as long as the economy keeps growing, fiscal Armageddon looks very unlikely. In Aesop’s fable of the boy who cried wolf, the boy is eventually vindicated by the arrival of a wolf. But the point of the story is that the villagers have become so tired of false alarms they don’t believe him. That point has not been reached in financial markets, which are still being thrown off balance by false alarms. When alarming news is ignored it will be time to worry.
As for the Magnificent Seven and other highly-rated growth companies, the only safe prediction is that articles about their inevitable demise will continue. A feature in MoneyWeek in June 2017 predicted the rise of a different Magnificent Seven, but four of the names were Chinese companies that have since fallen by the wayside in stock market terms. Past seemingly invincible giants such as IBM, Nokia, Dell, Intel and Cisco are now shadows of their former selves and the same may, eventually, happen to the giants of today.
However, sceptics of the potential for artificial intelligence (AI) should remember the observation of scientist Roy Amara, that “we tend to overestimate the effect of technology in the short term and underestimate the effect in the long term”. In 1943, Thomas Watson, chairman of IBM, said that he thought there was a world market for just five computers. Even the early bulls of mobile telephony never imagined that clunky car-phones would evolve into pocket-sized mini computers. History suggests that the bulls of AI will be proved right. Picking the right stocks and riding volatility is the key to investing in technology, much more than the timing of investment.
This article was first published in MoneyWeek’s magazine. Enjoy exclusive early access to news, opinion and analysis from our team of financial experts with a MoneyWeek subscription.
