Beware the Market’s ‘Invincibility Syndrome’

High Levels of Optimism Point to Potential Trouble Ahead

In a year defined by record highs, the Dow Jones Industrial Average (DJIA) has recently celebrated its 39th record close in 2023. The S&P 500 is tantalizingly close to its peak, just 0.3% off, while the Nasdaq Composite lingers only 1.5% below its all-time high. Despite some volatility, investors have shown a remarkable resilience in buying the dips, but this reaction has some seasoned professionals concerned. Michael Grant, co-chief investment officer and head of long/short strategies at Calamos Investments, warns that the prevailing ‘invincibility syndrome’ among investors could be a harbinger of more substantial problems on the horizon.

Understanding the ‘Invincibility Syndrome’

Grant identifies this ‘invincibility syndrome’ as a significant characteristic of the markets in 2023, suggesting that large segments of the investment community see U.S. equities as virtually untouchable. This sentiment can be partly attributed to the allure of major U.S. technology companies amid global economic fragmentation, leading many to believe that there are no substantial risks threatening market continuity.

As Grant articulates, this condition is historically a signal that we may be nearing a market peak. Unlike bear markets, which often emerge from visible panic and investor fear, ‘invincibility syndrome’ typically sets in when optimism runs rampant. When this occurs, it is common for market leaders to show signs of rotation and exhaustion in narrative cycles across various styles and industry segments.

Stretched Valuations Raise Red Flags

The evidence of this syndrome isn’t merely anecdotal; Grant backs his claims with compelling metrics. He notes that the Shiller cyclically adjusted price-to-earnings (P/E) ratio for U.S. equities has exceeded 35, marking the third highest level on record, only outdone when bond yields were at unsustainably low levels. The median P/E multiple of the S&P 500 currently stands at 28, a figure only seen during the dot-com peak of 1999.

Additionally, the price-to-sales ratios have returned to heights reminiscent of market exuberance levels seen in 2021. Perhaps most concerning, the three-month moving average of consumer sentiment with respect to stock performance has shot up to record levels. In a further affirmation of rising optimism, newsletter writers tracked by Mark Hulbert have become more bullish than at any point since 2000.

Invoking investor sentiment, Grant mentions that while such metrics speak volumes, extreme optimism signals significant risks when aligned with valuation and positioning measures. His penetrating question lingers: What remains to elevate the market when all investors have already bet on upward trends?

Low Cash Holdings Paint a Grim Picture

Much has been said about the $6 trillion parked in money-market funds, with arguments suggesting it’s poised to flood into the equity market. However, Grant suggests that when viewed against overall equity market capitalization, the current levels of cash aren’t particularly extraordinary. In fact, cash as a percentage of assets in equity mutual funds is at historically low levels, raising questions about the market’s underlying resilience.

Recession Rumors and the Misjudgment of Bull Markets

Despite the collective belief that only a recession could break the bull run, Grant strongly contends that investors are miscalculating the landscape. The bear market from 2000-2003 serves as a stark reminder that recession can emerge as a consequence of asset price deflation, not its root cause. The prevailing assumption operates on a projection of S&P 500 earnings growth through 2025 of 10% to 15%, fueled by continued economic expansion. However, keep in mind that such an outlook does not necessitate dropping the fed funds rate below 3% or yields on the 10-year Treasury dipping below 3.5%.

Grant’s analysis indicates significant potential headwinds arising from flattening long-term risk-free yields. If we’re to believe projections that aim for the S&P 500 to breach the 6000 mark, 2024 would then become the most lucrative year thus far for U.S. large-cap equities. Yet, this potential gains pale in comparison to the ever-growing signs suggesting we might be at the summit of this bullish cycle.

A Call to Vigilance

Hence, the ‘invincibility syndrome’ permeating the markets should serve as a formidable warning bell for investors. As Michael Grant cautions, financial markets can flip sentiment on a dime, and when they do, it can send shockwaves throughout the investing world. It’s crucial for investors, both seasoned and novice, to heed the warning signals that may well outline a rough patch ahead. In this climate of optimism, prudence and vigilance must remain at the forefront of investment strategies.