Why Investors Should Worry About the Market's 'Invincibility Syndrome'

The Dow Jones Industrial Average (DJIA) has recently achieved its 39th record close this year. The S&P 500 is currently just 0.3% away from its peak, while the Nasdaq Composite is trailing by 1.5%. Despite some volatility in recent trading sessions, investors continue to buy the dips, exhibiting a resilient attitude in the market.

‍

However, this unwavering confidence has raised concerns for Michael Grant, co-chief investment officer and head of long/short strategies at Calamos Investments, a Naperville, Illinois-based firm that managed $33.7 billion in assets at the end of 2023. Grant believes that a significant characteristic of the current investment climate is the perception of U.S. equities as virtually invincible, a sentiment that has taken hold among many investors.

‍

This perception is partially fueled by the appeal of major U.S. technology companies, particularly amid global economic fragmentation. Grant warns that this so-called “invincibility syndrome” may indicate that markets are approaching a critical juncture, as it has historically signaled a peak in market conditions.

‍

He acknowledges that identifying market tops is often more challenging than spotting bottoms. While market bottoms are generally accompanied by evident signs of stress and intense investor fear, market tops can manifest through persistent investor optimism. “Investor optimism can become a chronic condition,” he explains, noting that equity peaks are typically extended periods characterized by a rotation of narratives across different styles and sectors until they reach a state of exhaustion.

‍

It is during these times that the invincibility syndrome emerges, and Grant sees indications of it manifesting now through various metrics. For instance, the Shiller cyclically adjusted price-to-earnings (P/E) ratio for U.S. equities has climbed above 35, marking the third-highest level on record, surpassed only when bond yields were exceptionally low. Furthermore, the median P/E ratio of the S&P 500 stands at 28, reminiscent of levels seen during the dot-com bubble in 1999. Price-to-sales ratios have also returned to levels not observed since the market highs of 2021.

‍

Additional evidence of heightened optimism can be found in the three-month moving average of the Conference Board’s survey regarding American consumers' stock market expectations, which has reached an all-time high. Grant also points out that newsletter writers tracked by Mark Hulbert have adopted a bullish stance not seen since 2000, further supporting the notion of widespread investor optimism.

‍

“Investor sentiment doesn’t accurately reflect the extent of risk,” Grant notes. He highlights that extreme sentiment readings gain significance when they align with other metrics of valuation and positioning. “What can continue to drive the market upward if everyone is already bullish?” he questions, emphasizing a potential lack of upward momentum in the face of prevailing optimism.

‍

Currently, global investors' cash holdings are at notably low levels. Some believe that there is approximately $6 trillion in money-market funds poised to enter the stock market. However, Grant argues that when evaluated relative to the equity market's overall capitalization, the current level of money market funds is not extraordinary. He adds that cash as a percentage of assets in equity mutual funds has reached historically low levels, further complicating the landscape.

‍

So, what could trigger a shift in this prevailing invincibility syndrome? Grant contends that the widespread belief among investors that only a recession could end the bull market is misguided. He references the bear market from 2000 to 2003, which demonstrated that recessions can result from, rather than cause, declines in asset prices.

‍

Instead, Grant suggests that the prevailing market assumption is that S&P 500 earnings growth will range between 10% and 15% through 2025, relying on expectations of sustained economic growth. However, this scenario does not necessitate a drop in the federal funds rate below 3% or a decline in the 10-year Treasury yield below 3.5%. Grant believes that the realization that the long-term trend of decreasing risk-free yields has come to an end will create downward pressure on stock prices.

‍

“Reaching the 6000 mark for the S&P 500 would imply that 2024 is shaping up to be the most rewarding year for large-cap U.S. equities in this century,” he asserts. Yet, this possibility pales in comparison to the accumulating evidence that we may be witnessing a peak—a summit for equities that could be quite enduring.

‍

“Today’s ‘invincibility syndrome’ suggests that when financial markets decide to change direction, they can do so with remarkable force,” Grant concludes, highlighting the potential for sudden and significant market shifts. As such, investors would be wise to remain vigilant and critical of prevailing sentiments, as the landscape could shift rapidly.

‍