In the Twilight Zone

Unless you are in the business, you have difficulty understanding what's "normal" and what's "not normal". And with investing, those ranges can be rather wide. This chart does a pretty good job of showing one way we are in the Investing Twilight Zone.

I want to note this specifically because this chart goes back to 2003. That may seem arbitrary, but it is not. It specifically EXCLUDES the valuation bubble of 2000. So we are not comparing the variables to a different historical period where monetary and fiscal policy were totally different. I think that adds dramatically to the conclusions we can draw.

It's pretty straightforward, lower yields have led to higher P/Es and vice versa. But now bond yields have gone up pretty dramatically...

So what’s interesting here is that Bernstein has added a couple of extra dots (red and black) to show what specific groups are doing. And we can draw a couple of conclusions.

1. The current market is trading at a 19x multiple, and that is on the high end of the regression. This means all else equal, the market is overvalued at these bond yields, and we would typically be trading at a lower multiple. (Remember the time period context here) So we should expect a reversion.

2. The split the S&P into the “Magnificent 7” (Apple, Microsoft, etc.) and the Rest. It’s quite unbelievable that the Mag7 is in “the white space”. The white space is like being in the Twilight Zone where nothing makes sense. In my experience, you don’t live in the white space indefinitely. So that has meant a hard reversion back to the cluster at some point. (Obviously WHEN the reversion happens is the billion dollar question)

3. Lastly, note the rest of the market is near the best fit line suggesting that the Rest is around “fair value”. So the weight of the Mag7 is PULLING the broader index much higher in the regression. And this distance between the S&P and the Mag7 shows just how concentrated the market has become.

So what are the takeaways?

To me, this is a good illustration of how the market is a house of cards. So much confidence and expectation is pinned on the Mag7 that there is little room for error. We’ve seen the confidence begin to wane last week. And the main problem is that the disconnect is so large. The changing of that momentum creates a tail risk.