The recent movements in the stock market have been quite puzzling. Market laggards like small-cap stocks have unexpectedly started to outperform, while mega-cap tech stocks have begun to stumble. This rotation has led many to believe that the S&P 500 might see further gains as the market broadens out from its previous focus on artificial intelligence. However, Chief Investment Strategist Sam Stovall from CFRA Research is skeptical and anticipates a looming correction in the S&P 500, possibly in September, and the correction could be in the low double-digits.
Stovall’s concern primarily stems from the overbought nature of large-cap tech stocks. He highlighted that the S&P 500 is currently trading at a 37% premium to its average 20-year price-to-earnings ratio, but tech stocks, which have a significant presence in the index, are trading at a whopping 75% premium. The relative strength of the cap-weighted tech sector compared to the equal-weighted sector has also reached peaks not seen since 2000, indicating that large-cap tech stocks are extremely expensive.
Market Imbalance
Another factor working against the S&P 500 is the imbalance in the market. Large caps represent over 92% of the entire U.S. stock market, with small- and mid-caps making up only 8% of the market value. Stovall pointed out that expecting the meager 8% to counterbalance the massive 92% in a market downturn is akin to draining one of the Great Lakes into a swimming pool – an overwhelming and improbable task.
Stovall advises investors to tread cautiously and not bet the farm on the current market conditions. While the ideal scenario for the S&P 500 would involve large-cap stocks trading sideways and small- and mid-caps outperforming, investors should brace themselves for a potential downturn. Stovall recommends taking profits from fully valued or overvalued large-cap stocks and rotating into attractive mid- and small-cap stocks or ETFs. However, he warns against going all-in, as in a declining market, there are few safe havens, and all assets are prone to varying degrees of decline.
The current market dynamics suggest that the S&P 500 could be on the brink of a significant correction, despite the recent rotation in stock performance. Investors should be vigilant, take profits where possible, and consider reallocating to less risky assets to weather the storm that may be on the horizon.
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