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Strong gains in June put US equities back into danger zone
Peter Garnry
Chief Investment Strategist
Summary: US equities extended their momentum June rising more than 5% but also pushing equity valuations into levels we have not seen since March 2022 before rising interest rates reset equities lower. The high equity valuations have been inflated by strong revenue and earnings expectations driven by the ongoing AI speculation that got further fueled today with the announcement that Inflection AI has raised $1.3bn for an AI-assistant. Besides high equity valuations investors should take note of the recent breakout in the US 10-year yield getting closer to 4% again.
Key points in this equity note:
- A strong June rally in US equities driven by AI speculation has lifted equity valuations back into expensive levels reflecting high expectations for future revenue and earnings growth.
- The high expectations for US equities will make the Q2 earnings season a key test and recent earnings releases from Accenture, Adobe, and Nike suggest that companies may not exceed expectations.
- The recent breakout in the US 10-year yield is also a growing risk factor for equities in the short-term as a breakout above the 4% level could set in motion a repricing of equities vs bonds.
AI speculation propels US equities into expensive land
The S&P 500 Total Return Index was up 5.3% in June as of yesterday’s close marking the end of a strong month with the AI fever carrying US equities higher. The overall picture has not changed much. Financial conditions in the US economy continue to ease, implied volatility remains low, and economic activity levels remain robust. So what can upset the US equity market?
There are two main risk factors for equities over the coming months. The first risk factor relates to equity valuation which reflects expectations for revenue and earnings growth. US equity valuations have for the first time in 15 months crept back above being one standard deviation expensive. How is the equity market expensive? On a P/E ratio of 21.7x compared to long-term average of 20.3x it does not look that expensive. The valuation metrics driving our aggregate valuation metric to expensive territory are the price-to-sales ratio currently at 2.5x compared to the long-term average of 1.7x and EV/EBITDA currently at 14.7x compared to the long-term average of 11.3x. The long-term expected real rate return for US equities at current levels does not look good.
Equity valuations are useless for timing and expensive equities can always get a lot more expensive if animal spirits and the underlying narrative is strong enough. Right now the AI narrative, that this new technology is creating a growth miracle, is strong enough and has not proven wrong. The AI theme is still red hot and today Inflection AI, co-founded by one of the previous co-founders of Google’s AI research lab called DeepMind, has raised $1.3bn on the idea of an AI-powered assistant called Pi. The company has no revenue. In many ways it feels like 2021 and 2000 are back again.
As said, the high equity valuations reflect high expectations and as such the equity market has become more sensitive to the upcoming Q2 earnings season. Because high expectations must square with realized reality in terms of revenue and earnings growth. Recent earnings releases from Accenture, Adobe and Nike last night have not met the high expectations and thus the upcoming Q2 earnings season could become a period of headwinds for equities.
The second risk factor for equities is the recent breakout in the US 10-year yield which is currently at 3.88%, the highest level since March before the US regional banking crisis broke out, and could be on its way to 4% as inflation seems stickier than what the Fed assumed just three months ago. If the US 10-year yield sustain the momentum and breaks above 4% it could change the dynamic in US equities slowly start a rotation out of equities.
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