Lock them up or let them ride? That’s a question investors may be pondering at this point in an unexpectedly fruitful year, as the calendar appropriately shifts from a season of false fear to a season of gratitude for life’s blessings. For most people, this is not a complete exit from stocks or a complete stay in stocks, but rather a moment to acknowledge the journey so far, set expectations, and perhaps a portfolio. The S&P 500 index is up 16.3% year-to-date to 6,840, almost exactly 2,000 points above its intraday low on April 7 at the height of the tariff panic. Including dividends, the increase is more than 17%. Even a solid 60/40 portfolio of stocks and bonds, represented by the Vanguard Balanced Index Fund, has returned a total of 13.1% this year, slightly above the long-term average of 8%. On a three-year trailing basis dating back to the end of the 2022 bear market and just before the start of ChatGPT, the S&P 500 delivered an annualized total return of 22.8%. According to Strategas Group, this is better than 90% of all three-year periods up to 1945. .SPX YTD Mountain What tended to happen after the S&P 500 3-year year-to-date gain hit the top decile? Over the subsequent six months, forward returns were slightly better than average, but average returns started to lag compared to the 1- and 2-year lookahead periods. The current rally has also been unusually stable and uninterrupted by unpleasant pullbacks. It has been about 130 business days since the S&P 500 ended its last 5% decline in April. According to investment analyst and blogger Urban Carmel, this is among the six companies with the longest such streak without a 5% decline in the past 40 years. This suggests that the clock is at least faintly ticking on this orderly advance, but the longest such run lasted more than twice as long as this one. And the first 5% pullback, no matter when it comes, usually doesn’t signal the ultimate top of a bull market. Usually bought for at least the eventual rise. The current heatwave is, on average, on the cusp of the best season of the year. Of the 21 times the S&P 500 rose 15% or more through October, all but one were positive this year, with an average gain of 4.7%, said Keith Lerner, chief information officer at Trust Wealth. What will happen if AI trade cools down? Part of the story here is that the market’s concentrated and sustained leadership in big-cap tech and other high-quality growth stocks favors the S&P 500 over most other broad benchmarks and active portfolios. Passive S&P 500 index funds have outperformed more than 70% of all large-cap mutual funds this year. And owners of such indexes benefit from the way these funds essentially let winners run. Given 500 stocks in an actively managed index, would most people allow their Nvidia position to grow to 8.5% without selling any shares, or would they allow their seven highest holdings to grow to 35% of their account?A year ago, rotation to equal weighting was a fashionable imperative. But the more balanced approach has worked well, and while it’s still trending higher, its total return this year is 8.7%, just over half of the market-cap weighted version. Of course, the nature of markets can change, and a downturn in AI trading would hurt the index more severely than a less concentrated portfolio, as it did in 2022 when the Nasdaq 100 fell nearly 30% from high to low. Jason Hunter, chef technical strategist at JPMorgan, explains the situation this way: “The contrasting performance of the cap-weighted S&P 500, which has been bullish since mid-summer, and the equally weighted S&P 500, which has stagnated, also helps explain the high dispersion within the index and the concomitant crowding of thin leadership.” He added: “Daily and weekly momentum indicators do not confirm new highs. All of the above points to rally fatigue, but these are also conditions that have persisted many times throughout the development of the rally in recent quarters, and in most cases with little impact.” As is the case with some frequency, last week’s action wasn’t all that impressive beneath the surface. The equally weighted S&P 500 index fell 1.75%, lagging the major indexes by 2.5 percentage points. And little by little, each of the major threads of the bullish story began to unravel. The Federal Reserve cut interest rates by a quarter of a percentage point, but sought to cast doubt on further rate cuts in December, sending home construction, local bank and retail stocks lower. A trade summit with China resulted in a tepid ceasefire rather than a breakthrough agreement. And while Magnificent 7’s earnings were perfectly strong and capital investment intentions were strong, the market was less responsive to Meta Platform (down 12%) and Microsoft (down 1%). It’s fair to withhold style points for such uneven rhythms, but Tony Pasqualiello, head of hedge fund coverage at Goldman Sachs, chimes in on a kind of market breadth agnosticism: “The recent rally has been particularly narrow. Yes. Is this a meaningful departure from the system that has dominated it for the past three years? No. Does this history tell us that it should? ” all points are well understood and claim to give the market the immediate benefit of the doubt, along with the most extensive assessment of the situation. Of course, we don’t lose sight, but we also remember that our march to heights compressed our risk-absorbing cushions along the way. What ‘hyperscalers’ earnings show Meta, for example, could easily cover the additional $30 billion in debt it issued last week to fund its AI ambitions. But more broadly, this data center build-out is increasingly dependent on leverage rather than surplus cash. Meanwhile, the Fed has halted balance sheet outflows in part because overnight money markets have begun to show signs of intermittent tightening. And investor sentiment has become more positive, if not alarmingly so. Here we see that the ratio of bulls to bears in Investors Intelligence’s Market Advisory Services survey has exceeded the “overly optimistic” threshold after months of caution following the April selloff. Be aware that, like last year, this rally could continue for some time with little market reward. However, it is no exaggeration to say that this is no longer a true “hate rally.” The main takeaway from the hyperscalers’ quarterly results was that they still don’t feel they have enough computing power to meet demand. Nvidia stock rose nearly 9% last week, adding $400 billion to its market value and accounting for most of the S&P 500’s net income. The correction in Meta’s stock showed that the Street either doesn’t have as much confidence in the company or perceives its strategy to be more hopeless and less certain than its peers. But for now, the market has largely accepted the way cloud and social media giants are funneling otherwise free cash flow to Nvidia and other AI infrastructure vendors. Here, the free cash flow yields of the big four spenders have fallen to below 2%. How quickly the standard investment case for these companies changed from “asset-scarce automated teller machines” to “builders of the physical future of computing.” As with many features of the current environment, this demonstrates a remarkable level of fortitude and “informed greed” among investors, and confirms the market’s resilience amidst macro volatility and bubble fears – a collective willingness to hang in there at least a little longer.
