US Stocks: Why The Bull May Be Temporarily Over

2025 May Resemble 2022 A Bit More Than The Past Two Years

Salve, cari subscripti!

Thank you for reading this week's edition of Closelook@US Stock Markets, dated December 20, 2024 👋.

A Closelook At This Edition

1. This Week's Action: The End Of The Bull Market As We Know It
2. US Economy: Sticky Inflation, Continued Growth, Fiscal Troubles
3. US Stock Market Seasonality: This Time May Be Different
4. Long-Term Analysis: Nasdaq 100, SP 500, R2K
5. This Week's Spotlight: TLT, Gold and Crypto
6. Knowledge Corner: A Close Look At 2022 And Why It Matters
7. Final Words: Buffett Cash vs. Market Cycles

(1) This Week's Action: The End Of The Bull Market As We Know It

On 24 November 2024, I stated:

I firmly believe that when the bond markets start to worry deeply about the federal deficit and debt and bond vigilantes push them south, moving prices of the TLT ETF to the bottom or even below its multi-month trading range, the stock market bull will end abruptly.

The Bond Vigilantes continue to challenge inflationary monetary and fiscal policies. Since September 18, they have tightened financial conditions to counteract the Federal Reserve's 100 basis-point cuts to the federal funds rate since September 18. Additionally, they appear to be pushing back against inflationary fiscal measures.

In an NBC interview, President Donald Trump stated that he would prefer to eliminate the debt ceiling, which would eliminate a significant obstacle to escalating government deficits.

Click here for a chart analysis of the TLT ETF

The US Treasury yield curve reached its steepest point of this cycle, with a positive spread of 26 basis points between the 10-year and 2-year yields. The yields on the 10-year and 30-year bonds also increased, reaching their highest levels since spring, trading around 4.55% and 4.75%, respectively.

While stronger economic data contributed to rising bond yields during much of Q3 and Q4, the current increase is driven by more concerning factors. Consequently, bond yields have increased since the Fed began easing in September despite a decline in the Citigroup Economic Surprise Index.

The dollar continued its advance, too. Since the lows around the GFC, the currency has appreciated by nearly fifty percent. On 24 November, I said I would expect the US Dollar Index to rise to the 115 level shortly. I maintain the forecast.

Click here for a chart analysis of the US Dollar Index

I see the yield differential between the US and Europe widening, pushing the Dollar up and the Euro down.

(2) US Economy: Sticky Inflation, Continued Growth, Fiscal Troubles

Recent market volatility was triggered by the Federal Reserve's hawkish stance on rate cuts, suggesting only two potential cuts next year instead of the previously anticipated four.

This shift is due to higher-than-expected inflation and continued economic resilience. The ongoing political uncertainty in Washington, D.C., adds to investor concerns.

The proposed continuing resolution (CR) to extend federal budgets until March 14, 2025, faces significant opposition. Conservative Republicans in both chambers, President-elect Donald Trump and tech leaders Elon Musk and Vivek Ramaswamy have voiced their disapproval of the 1,547-page document, which few have thoroughly reviewed. Failure to pass a CR could result in a government shutdown by Friday.

I anticipate market turbulence may persist through January for several reasons:

1. Some investors might defer profit-taking to early next year for tax purposes.
2. A potential longshoremen's strike in mid-January opposing port automation has gained Trump's support.
3. The incoming Trump administration is expected to issue numerous executive orders on its first day, including measures on tariffs and illegal immigration.

I see a possible 10% market correction as a potential buying opportunity rather than a cause for panic selling.

I do not foresee a recession or a full-fledged bear market materializing. I agree with Ed Yardeni’s year-end target of 7000 for the S&P 500. Losses may be more pronounced in some regions of the stock market

(3) US Stock Market Seasonality: This Time May be Different

The final quarter of the calendar year has historically been the best quarter of the SP 500. December, April, and November are traditionally the three best months of a calendar year.

On average, the 2-monthly period from November until December is also the best bi-monthly period of a calendar year.

Since 2013, price action has been positive, except for 2016, when Donald Trump won the presidential elections for the first time.

The average performance of the S&P 500 during November and December over the past ten years was approximately 4.41%.

Data shows that during election years, the S&P 500 has historically underperformed in the September-to-early-November period compared to non-election years.

Right now, mutual funds are drastically underweight the Mag 7.

While the story has been predominantly one of cost-cutting and efficiency gains, more companies are participating in the earnings recovery. Today, 60% of S&P 500 companies have positive EPS growth versus ~50% in 1Q 2023.

I expect the broadening trend in earnings growth to continue. The market may have anticipated this, so the broadening trend may not be enough to lift share prices in the months ahead

(4) Long-Term Analysis: Nasdaq 100, SP 500, R2K

The bullish channel of the SP 500 is still intact, and the same is true for the Nasdaq 100 index.

However, the short-term bull channel since the summer of 2024 may be broken to the downside this week.

Click here for a chart analysis of the SP500

The Nasdaq 100 found support at the short-term bull market trendline and moved back to its summer 2024 highs. However, negative divergences have mounted.

Click here for a chart analysis of the Nasdaq 100

The Nasdaq 100 Equal Weight Index has already broken the short-term bull channel to the downside.

Click here for a chart analysis of the Nasdaq 100 Equal Weight

The Nasdaq 100 Technology Index failed to make a new ATH in the fourth quarter of 2024. It has broken the short-term bull channel to the downside.

Click here for a chart analysis of the Nasdaq 100 Equal Weight

Since the summer of 2024, the Nasdaq 100 Ex Tech Sector has outperformed the rest of the tech sector. It made a new ATH but also broke below the bull trendline.

Click here for a chart analysis of the Nasdaq 100 Ex Tech Index

The Nasdaq 100 TOP 30 index has been among the best performers of the various Nasdaq 100 subindices.

Click here for a chart analysis of the Nasdaq 100 Top 30 Index.

As expected, the weakness was short-lived, and the big companies dominated their smaller peers.

The Nasdaq 100 ex Top 30 Index, which covers the other 70 stocks of the index, has performed miserably in the past weeks.

The relative megacap tech strength can also be seen in the performance of the US Top 20 index.

Once highflying, VanEck Semiconductor ETF reached a peak in early July 2024. Since then, it has moved sideways.

Click here for a chart analysis of the VanEck Semiconductor ETF

The recently introduced fabless VanEck Semiconductor ETF (SMHX) has outperformed the broader SMH ETH.

Click here for a chart analysis of the VanECk Semiconductor fabless ETF

The bull market in R2K stocks may already be over. After reaching an ATH after the election, the index gave back all its gains and is now back at its July 2024 levels.

Click here for a chart analysis of the R2K index

The Dow Jones Industrial Average performed similarly miserably.

The Dow Jones Transportation Index failed to confirm the ATH of the DJIA, which is a negative divergence.

(5) This Week's Spotlight: TLT, Gold and Crypto,

In line with other risk-on assets, gold has declined recently. The bull market may be over, too, for quite a while.

Click here for a chart analysis of Gold.

This also applies to Bitcoin. We'll likely move back to the 85,000 - 90.000 level before another leg up occurs.

Click here for a chart analysis of Bitcoin.

I expect 2025 to be a bit more like the first half of 2022 than the bulls would like. This would be negative for nearly all assets but should not extend to a full-fledged bear market.

Share

(6) Knowledge Corner: Multiple Expansion, Multiple Contraction

In share price valuation, the concept of the numerator and denominator provides a simplified framework for understanding how earnings growth and interest rates influence stock prices.

The numerator represents a company's earnings or expected earnings growth, which drives the intrinsic value of a stock. When earnings growth accelerates, it increases the potential future cash flows available to shareholders, thereby boosting the stock's valuation.

Conversely, the denominator reflects interest rates, which serve as a discount rate in valuing those future cash flows. Lower interest rates reduce the discount rate, making future earnings more valuable in present terms and driving stock prices higher. Conversely, rising interest rates increase the discount rate, reducing the present value of future earnings and exerting downward pressure on stock prices.

This interplay highlights how stock valuations are sensitive to corporate performance (numerator) and macroeconomic conditions (denominator).

To illustrate how multiple expansion based on interest rate expectations can lead to losses when those expectations change, let's consider a hypothetical scenario for the Nasdaq in 2024-2025:

2024: Multiple Expansion Driven by Rate Cut Expectations

In 2024, the Nasdaq index rose by 30%, from 15,000 to 19,500 points. Let's break down this increase:

• 15% increase due to earnings growth
• 15% increase due to multiple expansion based on expectations of lower interest rates

The price-to-earnings (P/E) ratio expanded from 25 to 28.75, reflecting optimism about future rate cuts.

2025: Revised Rate Expectations and Market Reaction

In 2025, despite earnings meeting expectations and growing by 10%, the market faces headwinds due to revised interest rate projections:

1. Earnings per share (EPS) increases by 10% as expected
2. However, the Federal Reserve signals fewer rate cuts than anticipated
3. This leads to a contraction in the P/E ratio from 28.75 back to 25

Calculation

1. Starting Nasdaq level: 19,500
2. EPS growth: 10% (19,500 * 1.10 = 21,450)
3. P/E contraction: From 28.75 to 25 (21,450 * (25/28.75) = 18,652)

Result

• Nasdaq falls from 19,500 to 18,652
• This represents a 4.35% decline despite 10% earnings growth

Analysis

This example demonstrates how multiple expansion based on interest rate expectations can create vulnerability in the market. When these expectations are not met, even if corporate earnings perform as anticipated, the market can experience losses due to the contraction of valuation multiples.

The scenario underscores the importance of considering both fundamental factors (earnings growth) and market sentiment (valuation multiples) when assessing potential market movements. It also highlights the significant impact of interest rate expectations on equity valuations, particularly for growth-oriented indices like the Nasdaq.

Investors should be cautious when markets experience substantial multiple expansion based on rate cut expectations. This can create a situation in which even positive earnings growth may not be sufficient to prevent market declines if those rate expectations are not realized.

The impact of interest rate expectations on stock valuations is particularly pronounced for growth companies with little to no current profits but high anticipated growth rates. The discounted Cash Flow (DCF) model effectively explains this phenomenon.

DCF Model for Growth Companies

The DCF model heavily weighs future cash flows for growth companies, as current profitability is often low or negative. The general formula is:

Present Value=∑t=1nFuture Cash Flowt(1+r)tPresent Value=t=1∑n(1+r)tFuture Cash Flowt

Where:

• rr is the discount rate (closely tied to interest rates)
• tt is the time period
• nn is the number of periods

Sensitivity to Interest Rates

Growth companies are particularly sensitive to changes in the discount rate for several reasons:

1. Distant Cash Flows: Most of their value is derived from cash flows projected far into the future.
2. Compounding Effect: Small changes in the discount rate have a magnified effect on cash flows discounted over many years.
3. High Growth Assumptions: The model often assumes high growth rates for an extended period, making the terminal value highly sensitive to the discount rate.

Example Scenario

Consider a hypothetical tech startup with the following characteristics:

• Current annual revenue: $10 million
• Expected growth rate: 50% per year for 5 years, then 20% for 5 years
• No current profits, but expected to reach 20% profit margin in year 10

Scenario 1: Low Interest Rate Environment

• Discount rate: 6%
• Calculated present value: $500 million

Scenario 2: Higher Interest Rate Environment

• Discount rate: 8%
• Calculated present value: $350 million

In this example, a mere two percentage point increase in the discount rate results in a 30% decrease in the company's valuation.

Multiple Expansion and Contraction

When interest rates are expected to decrease:

1. Investors apply lower discount rates in their DCF models.
2. This leads to higher present values of future cash flows.
3. As a result, valuation multiples (e.g., Price-to-Sales) expand significantly.

Conversely, when interest rate expectations shift upward:

1. Discount rates in DCF models increase.
2. The present value of future cash flows decreases dramatically.
3. Valuation multiples contract sharply.

Market Implications

This sensitivity explains why growth-heavy indices like the Nasdaq can experience outsized gains when interest rates are expected to fall and equally dramatic losses when rate expectations reverse, even if the underlying growth prospects of these companies remain unchanged.

Investors in growth stocks must be particularly vigilant about the interest rate environment and how shifts in rate expectations can lead to rapid and significant changes in valuations, even when company fundamentals remain strong.

A 1% increase in long-term interest rates by the end of 2025 compared to current expectations would likely have significant impacts on Nasdaq 100 companies and high-beta growth stocks:

Impact on Nasdaq 100 Companies

1. Valuation Pressure: Higher long-term rates would put downward pressure on valuations, particularly for companies with high price-to-earnings ratios. This could lead to multiple contraction for many Nasdaq 100 constituents.
2. Mixed Effects on Earnings: While higher rates may increase borrowing costs, many Nasdaq 100 companies have large cash reserves earning higher interest income. For instance, companies like Google earn significantly more in interest income than they pay in interest expenses.
3. Sector-Specific Impacts: Technology companies, which dominate the Nasdaq 100, may face more significant valuation adjustments due to their growth-oriented nature

Impact on High-Beta Growth Companies

1. Amplified Volatility: By definition, high-beta stocks tend to react more strongly to market movements. A rise in long-term rates could increase their volatility.
2. Valuation Compression: Growth companies with little to no current profits but high anticipated growth rates would likely see more substantial valuation compression. This is because their future cash flows would be discounted more.
3. Financing Challenges: Higher rates would increase the cost of capital for growth companies, potentially impacting their ability to fund expansion and innovation

Quantitative Perspective

Using a simplified discounted cash flow (DCF) model:

• For a high-growth company with a current P/E of 40x, a 1% increase in the discount rate could potentially reduce its valuation by 20-30%
• For the broader market (e.g., S&P 500) with a P/E around 15x, the same 1% increase might lead to a 10-15% valuation reduction

Mitigating Factors

1. Earnings Growth: Strong earnings growth could partially offset the negative impact of higher rates, especially for quality growth stocks
2. Cash Reserves: Many Nasdaq 100 companies have substantial cash reserves, which would benefit from higher interest rates
3. Market Adaptation: If the rate increase is gradual, markets may have time to adjust, potentially reducing the shock to valuations.

In conclusion, while a 1% increase in long-term rates would likely pressure valuations, particularly for high-beta growth stocks, the impact on Nasdaq 100 companies could be more nuanced due to their strong balance sheets and potential benefits from higher interest income. Investors should closely monitor company fundamentals and sector-specific dynamics when assessing the possible impact.

The first half of 2022 provides an excellent example of how rising interest rates impacted high-growth technology companies like Cloudflare, Datadog, and MongoDB. These companies experienced significant valuation shifts as the market adjusted to a changing interest rate environment.

Revenue Growth Remained Strong

Despite the challenging macroeconomic conditions, these companies continued to demonstrate robust revenue growth:

• Cloudflare reported Q1 2022 revenue of $212.2 million, up 54% year-over-year
• Datadog's Q1 2022 revenue grew 83% year-over-year to $363 million
• MongoDB saw Q1 fiscal 2022 revenue increase by 39% to $181.6 million

Valuation Compression

However, despite strong revenue growth, these companies experienced significant valuation compression:

• Cloudflare's stock price declined by approximately 60% in the first half of 2022.
• Datadog's stock price fell by around 40% during the same period.
• MongoDB's stock price dropped by about 50% in the first six months of 2022.

This valuation compression occurred as investors reassessed the present value of future cash flows in light of rising interest rates.

Impact of Interest Rates

The Federal Reserve began raising interest rates in March 2022 to combat inflation. This had a disproportionate impact on high-growth tech stocks:

1. Higher discount rates: As interest rates rose, investors applied higher discount rates to future earnings, reducing the present value of expected cash flows.
2. Multiple contraction: Price-to-earnings (P/E) and price-to-sales (P/S) ratios contracted as the market recalibrated valuations.
3. Shift to profitability: Investors began prioritizing near-term profitability over long-term growth potential.

Company-Specific Responses

These companies responded to the changing environment by emphasizing efficiency and path to profitability:

• Cloudflare focused on demonstrating operating leverage, with non-GAAP operating margin improving to 5.8% in Q1 2022
• Datadog highlighted its strong profitability, with a non-GAAP operating income of $83.7 million in Q1 2022
• MongoDB emphasized its improving gross margins and progress toward profitability

Cloudflare, Datadog, and MongoDB's experiences in the first half of 2022 illustrate how rising interest rates can significantly impact high-growth tech stocks, even when their underlying businesses continue to perform well. This period underscores the importance of considering both growth prospects and valuation metrics when investing in technology companies during changing interest rates.

Mega-Cap Tech Companies

Microsoft (MSFT)

• Q3 FY2022 (ending March 31, 2022) revenue: $49.4 billion, up 18% year-over-year
• Strong cloud performance with Azure revenue growth of 46%
• The stock price declined by approximately 20% in the first half of 2022

Apple (AAPL)

• Q2 FY2022 (ending March 26, 2022) revenue: $97.3 billion, up 9% year-over-year
• iPhone revenue grew 5.5% year-over-year to $50.6 billion
• Stock price declined by about 20% in the first half of 2022

Lower P/E Grower

Walmart (WMT)

• Q1 FY2023 (ending April 30, 2022) revenue: $141.6 billion, up 2.4% year-over-year
• U.S. comp sales grew 3%, and eCommerce growth was 1%
• The stock price declined by approximately 15% in the first half of 2022

Analysis

1. Growth Rates: The high-growth tech companies (Cloudflare, Datadog, MongoDB) maintained impressive revenue growth rates ranging from 54% to 83% yearly. In contrast, the mega-cap tech companies (Microsoft and Apple) showed more moderate growth rates of 18% and 9%, respectively. Walmart, a lower P/E grower, had the lowest growth rate, at 2.4%.
2. Stock Performance: Despite strong revenue growth, the high-growth tech companies experienced the most significant stock price declines in the first half of 2022, ranging from 40% to 60%. The mega-cap tech companies fared better but still saw declines of about 20%. With its lower valuation multiples, Walmart had the smallest drop at around 15%.
3. Valuation Impact: The disparity between revenue growth and stock performance for high-growth companies suggests a significant compression in valuation multiples. This likely reflects changing market sentiment toward high-growth, high-value stocks in an environment of rising interest rates and economic uncertainty.
4. Sector Resilience: While all companies faced headwinds, Microsoft, Apple, and Walmart's more diversified businesses demonstrated greater resilience in terms of stock performance. Their established market positions and more predictable cash flows likely provided some insulation from market volatility.
5. Customer Dynamics: High-growth companies like Cloudflare and Datadog continued to add customers at a rapid pace, particularly in the enterprise segment. This suggests ongoing demand for cloud and digital transformation services despite economic concerns.

In conclusion, the first half 2022 saw a significant divergence between fundamental business performance and stock market valuations, particularly for high-growth tech companies. While these companies maintained strong revenue growth, their stock prices suffered disproportionately compared to their more established, lower-growth counterparts.

This period highlighted the market's shifting preference towards companies with proven profitability and lower valuations in the face of macroeconomic uncertainties. This may happen again in the first half of 2025.

(7) Final Words: Buffett Cash vs. Market Cycles

Warren Buffett’s cash hoard often spikes before equity market slowdowns. He has been a leading indicator of price action to come.

On 24 November, I wrote that I expected a more significant correction/consolidation to start in the spring of 2025. It remains to be seen whether we have already seen the top or whether we will see one more bull leg before a more significant consolidation sets in. Given the force of the recent decline and the technical damage already done, I am inclined to think that we may see another failing bull attempt.

Seth Golden points out in the table below that the average length of a bull market not preceded by a recession is 33 months. That would take this bull market cycle out until May 2025 only.

Here is a close look at where this current bull market is compared to other bull markets dating back to 1957. The table is from the summer of 2024, so please add four months to the current bull market.

This bull market (26 months) is five months longer than the shortest bull market in history, the last one, which ended in January 2022.

Don’t Fight The Fed, And Don’t Argue With The Tape

This has been one of my main signposts in investing. Since this week, it may mean stopping to buy the dip and selling any meaningful rip.