Market Bubbles Expand for a Longer Period of Time Than Many People Anticipate. The Metric Shows Valuations Matter, However.

Wall Street has experienced volatile trading recently. The CBOE VIX index, which measures anticipated S&P 500 volatility, rose to 18 midweek—its highest since April—amid heavy selling of large-cap technology stocks, unsettling investors.

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The discussion centered on a significant shift towards smaller companies that might benefit from lower interest rates and a robust economy, funded by a waning enthusiasm for AI-related stocks.

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However, John Higgins, chief market economist at Capital Economics, believes this trend won't last long. Higgins asserts that a sustained and substantial rotation into small-cap stocks won't commence until just before a major market correction. He predicts that this bubble won't burst until 2026.

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Higgins compares the current AI-driven market to the dotcom bubble, suggesting that "AI is another transformative technology, the benefits of which investors will continue to seek to crystallize upfront." He anticipates the S&P 500 could climb to 7,000 by the end of 2025 as the bubble inflates, with the index reaching a next twelve-month price-to-earnings ratio of 25, similar to the dotcom peak.

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Currently, the S&P 500's forward P/E ratio is about 21, indicating that valuation expansion will largely drive future gains. This scenario poses challenges for value- and cash flow-focused fund managers like Chicago-based Distillate Capital. In their second-quarter 2024 update, they acknowledged that their strategy had caused some of their funds to trail the market in 2024.

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Distillate also likens the present environment to the late 1990s, emphasizing the importance of adhering to valuation discipline. The firm prefers using free cash flow yield as a valuation metric, which they argue avoids accounting distortions that undermine traditional metrics in an increasingly asset-light economy.

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Despite this, Distillate acknowledges that valuation alone is not helpful for predicting short-term stock market returns. This is evident from a chart showing the S&P 500's free cash flow yield overlaid with its one-year forward return, indicating a seemingly random relationship. However, when free cash flow yield is compared to the 10-year forward stock market return, a strong relationship emerges.

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"While the one-year results seem random and free cash flow valuation appears largely irrelevant for market direction, the price paid is crucial for long-term returns," says Distillate. They note that the S&P 500's current trailing yield of 3.3% is in the 14th percentile of its roughly 40-year history, indicating that the market has been cheaper 86% of the time.

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In market news, U.S. stock indices, including the S&P 500, DJIA, and COMP, opened higher as benchmark Treasury yields dipped. The dollar index remained steady, oil prices declined, and gold traded around $2,379 an ounce.

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The buzz includes the Federal Reserve's preferred inflation gauge, the core personal consumption expenditure price index, which rose 2.6% year-over-year in June, matching the previous month's increase. U.S. consumer confidence data for July will be released at 10 a.m. Eastern.

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In regulatory news, the SEC charged short seller Andrew Left and his firm, Citron Capital LLC, with a $20 million scheme to defraud followers by publishing false and misleading stock trading recommendations.

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On the corporate front, Bristol Myers Squibb shares surged over 8% following second-quarter earnings that beat Wall Street expectations, driven by strong sales of major drugs like Opdivo. Conversely, DexCom shares plummeted nearly 40% after the diabetes monitoring device maker cut its full-year sales outlook. Deckers Outdoor shares rose nearly 12% after positive results from its Hoka and Ugg brands led to an increased full-year profit forecast.

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Finally, the Paris 2024 Olympic Games officially kick off on Friday.

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