Stock Valuation Check Up and a Semiconductor Breakout

Jeff Buchbinder:

Hello everybody, and welcome to the latest LPL Market Signals podcast. Jeff Buchbinder here, your host for this week, with my friend and colleague Adam Turnquist. We've got a great show for you here today. There is so much going on and stocks at all-time highs, or very close to all-time highs, a Fed meeting, earnings season, jobs report. Just a ton to get through so let's jump right into it, Adam. We'll start with a recap of last week's market performance, where we saw the energy sector lead. Next we're going to talk valuations, you know, with stocks at all-time highs, at least based on the S&P. That's a natural question to ask, if stocks are overvalued. Next, Adam will walk through some charts that, of course, is his specialty, looking at semiconductors in particular and more. But semis have broken out, which is always a popular group. It's one of the biggest industry groups in the entire market, and acts as kind of a barometer for market risk, I would say. Kind of like what the transports used to be. So interested, Adam, in your thoughts there and then the week ahead, as I mentioned, just a ton to get to. So start with a recap. So S&P up about 1% last week, solid week. That of course got us to pretty much a new high. I think as we're recording this, it's Monday, January 29, 2024. I think we're at another all-time high as we speak. Stocks were up four out of five days last week. Be interested, Adam, in your thoughts on whether we're overbought when we get to the, or how overbought we are when we get to the S&P 500 chart.

Jeff Buchbinder:

But certainly good week for stocks. Small caps did even better than the S&P up about 1.7%. So a little bit of evidence that investors are embracing risk. The sectors certainly were cyclical. Energy of course benefiting, not for good reason, benefiting from the increase in geopolitical tensions in the Middle East. Although the cold weather has drawn down inventories or at least contributed to it. So that's part of the story there. But huge week for energy, up over five, and oil prices, up similarly. Also strong week for communication services, which benefited from strong results from Netflix. It was a little bit of a value-oriented week last week; value slightly outperformed, although growth still leads year to date. And then international markets actually did pretty well. So we had China stimulus, which markets responded favorably to, so we had big gains in Hong Kong. Pretty big gains in China, and I think that spilled over to Europe where we had solid gains there as well last week. So any comments on the global equity returns for last week, Adam? Anything I omitted?

Adam Turnquist:

I think the one thing to watch for this week, because we're wrapping up January, is the January Barometer, of course. So we've good point. Struggled out of the gate here for the S&P 500, snapping that nine-week winning streak at the start of the year. But we've, so far, we're back in the black coming into month end. Of course, a positive January has been a positive signal for the market. If you go back to 1950, whenever January is positive, you get kind of average and median returns for the full year, right around 17 to 18% higher, nearly 90% of the time. So certainly a positive seasonality signal that we're looking for this week that would maybe help offset the negative seasonality signals that we started the year with the negative Santa Claus rally, the negative first five days. So keep an eye on that and if we do get that positive monthly close here. And I think in terms of the international space, just, there's a lot of questions coming in about has China bottomed? I think this looks more like a relief rally off oversold levels. We're really not seeing any definitive trend change in a lot of the Chinese indices that we watch. So I think it's more of a buyer beware market right now for the broader Chinese equity space.

Jeff Buchbinder:

A hundred percent agree with that. Yeah, it might be setting up for an interesting short-term trade. But we, like many, just don't love the idea of a long-term investment in China here right now. So thanks for that, Adam. Yeah, hopefully we'll finish January strong. It looks like, you know, we're up almost 3% month to date, so looking good for that market pattern. Turning to bonds. It was not really exciting for the Agg; up a marginal, you know, 0.1%, but we did have a nice gain for high yield. You know, that's the most equity sensitive area of the bond market. So if stocks are rallying and you have investors embracing risk, you're going to see some gains in high yield so that makes sense. Really good gains for the preferred market too last week.

Jeff Buchbinder:

An area that we at LPL Research have liked. So turning to commodities, I mentioned the oil price rally last week, up almost five. It was certainly very cold the last few weeks in many parts of the country so finally, natural gas responded to that and was up double digits. And then the China sentiment, I think, lifted the industrial metals complex a little bit. We had copper up 2% and silver, which is kind of a hybrid industrial precious, up nicely last week as well. So yeah, kind of a, you know, recovery for global economic sentiment, I think you would say, maybe in part. But you know, at the same time it was really the geopolitical scene that caused, I think, most of the move in energy. So let's move on.

Jeff Buchbinder:

Of course, got a lot of earnings last week. Here's the earnings dashboard that we run every week during earnings season, and frankly, it didn't really change last week. We still have a huge drag from these bank charges. But you know, some of the sectors that are doing better or worse beyond financials have moved around a little bit. So it looks like now the biggest surprises are coming from industrials and tech. I think the surprise in industrials make some sense because the economy surprised in the fourth quarter. So certainly a lot of those companies are benefiting. I know we had pretty good results out of the trucking area. We had pretty, you know, pretty good results out of some conglomerates, like GE. We had some pretty good results out of defense. So that's an interesting maybe trend to watch.

Jeff Buchbinder:

But tech's where we really expected the best results and the sector is certainly delivering. Although it hasn't, we haven't seen too many companies report yet. This week is a big one, as I'll get to here in a little bit. We always watch guidance and what happens with forward estimates during earnings season to gauge whether the results are good or not. And, you know, they've been pretty good. Estimates have only dropped 0.7%. That is about in line with the historical trend, maybe a touch better at this point in time, but not materially so. So, you know, won't call that a win or a loss. It's just kind of, you know, typical and average. But then, you know, this might cause some people to think that maybe S&P 500 earnings can't grow as quickly this year. Well, we're going to push aside the big bank charges to replenish the FDIC deposit insurance fund and just look at what we do beyond that.

Jeff Buchbinder:

And I think there's a good chance still that we could see four or 5% earnings growth for the S&P outside of those big messy bank charges. So that's just a quick update on earnings. We get a lot more companies this week, and we'll have a lot better sense of, you know, just how strong they'll be after we get through the week. So let's go back over to you, Adam, to weigh in on this chart. I mean, this, to me, my amateur chart reading skills tell me this is just beautiful.

Adam Turnquist:

It is, it is. Technically off the charts here. We're kind of running out of room in the top right corner of this S&P 500 chart, making continuous new highs here as momentum delivers as we've approached month end. You can see we're getting close to that 4,900 area. If you take this kind of consolidation range, this brief consolidation range, that we witnessed in January, and you measure that out and apply an upward price objective, it lands right around 4,915. So that would be the shorter-term area that we're looking for in terms of a minimum upside price objective from this breakout. But when we start digging into the technicals, looking underneath the surface of what's driving the market, I would consider breadth right now as robust, but maybe not validating quite this rally that we've seen. You can see about 74% of S&P 500 stocks above their 200-day moving average. Of that, when you look at the sector composition, it does lean to the more offensive sectors that are really driving this rally. However, we haven't seen a lot of new highs or 52-week new highs. That's the black bars underneath in the middle panel. And that's something I'm watching this week to see if we get further follow through, and a higher degree of S&P 500 stocks breaking out to new 52-week highs. I think that would be a good sign for the sustainability of this rally. And, of course, we can't forget about momentum and how overbought we are in terms of the market. That relative strength index back into overbought territory, which is what you want to see when you're breaking out to new highs. But, of course, as we know, bull markets are not linear and oftentimes you'll get a correction, or a pullback, when you start to get these high degrees of overbought conditions. I would not consider the market at that level now, but we're certainly building into that as we rally here with consistent new highs almost on a daily basis.

Jeff Buchbinder:

Okay, great. That doesn't sound too stretched, but certainly, you know, we want to watch this market closely given how far we've come. So thanks for that. You know, that tells us, actually the message is probably pretty consistent with valuations, right? This market might be a touch ahead of itself. Maybe needs to cool just a bit. Well, I think you could say the same thing about valuations. So we wrote about valuations in our Weekly Market Commentary for this week. You can find it now on LPL.com. And what we find is by most metrics, stocks are a little bit overvalued, but maybe not as much as you might think. So, you know, let's start with PEs. This is the one that, you know, most people know. Price turnings ratio on a forward 12-month basis for the S&P is just a little under 20, but, you know, which certainly is a little on the high side, but you might be surprised to learn that the five-year average is over 19.

Jeff Buchbinder:

So we have been in this range for much of the past five years so, is it expensive? Yes, but really not as stretched as you might think, even though the average is over the longer term or closer to 17. But there's a lot of different ways to look at valuations to get a more complete picture. So we factor in interest rates and calculate an equity risk premium. Regular listeners, you guys will know that this is something we've talked about before. You can take the PE and invert it to create an E divided by P. That's your earnings yield. Compare that to the Treasury yield, the 10-year Treasury yield, and essentially, it makes stocks and bonds comparable on an apples to apple basis, right? Essentially, earnings spun off from stocks compared to earnings spun off from bonds, which of course is your yield.

Jeff Buchbinder:

Compare those two. And because stocks are riskier, you want to get more of a premium there. That's the equity risk premium. Well look at the premium. Now, it's not much of a premium at all. It's about 0.1%. So that means you're really not getting much compensation to take on equity risk relative to fixed income risk. So stocks are fully valued, or fairly valued, maybe. Again, not super stretched, because they are in line with bond valuations but certainly not cheap. So there's another way to look at valuations. We also can look at cash flows, which are really a pure way of looking at valuations. And here, it's kind of the same story. You're a little overvalued relative to recent history, but not off the charts like that S&P 500 is that Adam just showed us.

Jeff Buchbinder:

So cashflow valuations, a little bit more of a pure valuation metric. You get away from the distortions of accounting treatment, right? Companies can shift earnings around based on how, you know, based on the accounting methods that they use. And sometimes, you know, earnings can be a little bit, I don't know, I don't want to say less trustworthy, but a little bit messier, right? So you kind of pull that out and you throw everything in there that companies are going to use cash for. It's sort of a purer way to value companies. So we like the cash flow measure. We're always looking at returns on capital, which parallels to cash flow, right? Because when you're talking about investing in capital that's really not captured by traditional earnings metrics. I know we're getting a little bit in the weeds.

Jeff Buchbinder:

The point here is, when you factor in investments in capital, right, like building plants in the old days, you get, well, here again, a more complete look at valuations. And I think this really highlights how profitable, you know, the big techs are. Okay, so look where returns on capital were around the time of the tech bubble, right? 3% or so. Where are they now? After we've had a 30 year, basically a 30 year productivity boom, of using technology, 7%, right? So companies are much more profitable. You see this in profit margins too, by the way, you see the same kind of uptrend, but it's not quite as dramatic. Companies are just making more profits per unit of capital investment than they did before. So why do I go through all that? To make the point that stocks are worth more today than they were 20 or 30 years ago, right?

Jeff Buchbinder:

And the analogy I like to use to just kind of bring this into the simplest terms, and Adam, I want you to weigh in on this, if you build something and you have to deliver it to the customer, you have to create, you know, build a factory, make the widget, get the materials, and ship it out, right? There's a limit to how much of a return you can earn on that capital invested. But look at an internet company. You build a webpage. Actually, Meta/Facebook is a good example of this. You build a website, you build a platform, people use it. The marginal cost to earn profit on that platform is essentially zero, right? So with big tech companies, and you could argue it's almost half the stock market today, these big tech companies' digitization of the economy are, they're very, very profitable generating very, very high returns on the capital that they invest, and that can support stronger cash flows in the future. So with that long, long diatribe, Adam, what do you think? Do you buy it?

Adam Turnquist:

It's a dangerous question to ask a technician on valuations because kind of the boiler--

Jeff Buchbinder:

I thought you were going to disagree with me and not challenge me. If I ask--

Adam Turnquist:

They generally don't matter until they matter, is what a lot of technicians would say. But I think based on my experience, and whether that's on the sell side or on the fixed income desk and looking at valuations over the years, whether they're full or high, there's always a story that is justified, right? And I think when we look to 2024, I think you've used the phrase valuations are maybe full. Hopefully that's still the case. And I'm not, I'm just kind of paraphrasing, but I think that the story helps justify, and I think you did a great walkthrough in terms of this return on capital. But of course you have artificial intelligence. I think if you're investing now and you're thinking about, okay, is the S&P rich to historical valuations, why could it trade at a premium?

Adam Turnquist:

Of course, you know, I think this chart helps make that case. If you think about what the Fed is doing, and we're moving from a rate hiking to rate cutting regime, that helps make the story and justifies some of the premium valuations that we're seeing in the market. So I think it's just part of the story that you see and, you know, you continuously hear this as valuations go up, people like to point to a market top because, just because of valuations. We've learned through history that that's really not the case. They're not exactly a great predictor of tops, at least initially when you start to see the market trade at more of a historical premium. So I think it all boils down to the story and I think when you think of 2024, it's a pretty compelling story for stocks when you think about the macro environment overall.

Jeff Buchbinder:

Yeah. Great points about valuations not being great timing tools year to year. It's also a pretty good time to buy a potential ramp in cash flows and earnings, right? We just came out of an earnings recession. Now earnings are starting to grow. You would hope cash flows would follow. So that might make this a better time to buy a slightly overvalued market as opposed to a period where earnings are already, you know, about as good as they're going to get or potentially poised to decline. So I think that's another important point. But the whole thing about, just build it once and sell it to one person, or build it once and sell it to many people, I think that's a really, really important point that's kind of underlying this richly valued market. So we'll say how long it can support the market. You know, eventually, I mean, you could get over hyped like we were in 2000. We'll have to see where it goes, but we don't think we're quite there yet. Artificial intelligence certainly has a ways to go. So thanks for that, Adam. A really interesting topic, I think, valuations and one that we're getting some questions on here lately. So let's turn back to the charts. So I'll let you run with this. You're starting with the Mag Seven, which has what, five of seven earnings reporting this week?

Adam Turnquist:

Yeah, it's going to be a big week for the Mag Seven. As you highlighted, several of the key names are reporting this week. And when you look at the technical setup, this is the equal-weight Bloomberg Magnificent Seven Index that they put together. And you can see it was just kind of stuck in this consolidation range for most or the latter half of 2023. We did dip into the start of this year and remember the headlines? Are the Magnificent Seven dead? And all of the, I think, skeptics out there, but clearly they're back in gear. They bounced right off support. They got a little bit overbought. Checked back, right to that area of that prior breakout area from that consolidation range, bounced off the rising 50-day moving average. So now we're seeing record highs for the Magnificent Seven. That momentum is continuing after what I would consider a healthy consolidation phase. And then on the bottom panel, when you think about leadership, obviously they were a major leader of the market last year. And we're seeing the Mag Seven versus the equal-weight S&P 500 close to breaking out to a relative new high on that lower panel. So when you see breakouts on an absolute and a relative basis, very constructive sign for the group. We'll be watching for further leadership in the Mag Seven. That's what the technicals are telling us right now.

Jeff Buchbinder:

Yeah, I'm starting to call it the Super Six. The Super Six. So that's the Seven ex Tesla is actually expected to grow earnings more than 50% in the quarter being reported. Some serious earnings growth coming out of that group.

Adam Turnquist:

Yeah, and FactSet had a report out on Friday highlighting the fact that, excluding Tesla, six of the other six names of the Mag Seven, are the top contributors to the S&P 500 earnings for fourth quarter. So some pretty big importance. So maybe they're, as pun intended, they're earning their keep in terms of their rally and their contributions to returns. I know that was a big topic last year. But here we have the, the semiconductors space. I wanted to highlight the technicals here. Just the fact that we talked about breakouts on an absolute and a relative basis, I thought this was a great example. This is the SOX index. And technically we call this a breakout from a cup-with-handle formation for anyone that read William O'Neill's book, "How to Make Money in Stocks." That was a popular technical pattern that he liked to highlight in that book.

Adam Turnquist:

But here you see a pretty convincing breakout from this cup-with-handle formation. In terms of the technical implications here, in terms of upside, you know, the minimum based kind of minimum technical price objective here would be around 20% higher. Of course, it doesn't happen overnight. You kind of take the length of this formation and then use that as an estimate to get to that level, so maybe a year and a half kind of timeline for that price objective. But on the bottom panel you can see semiconductors breaking out versus the S&P 500 as well. So, not only are they just breaking out on an absolute basis, they're also leading the market. And that's really been the trend for the last year when you look at the semi space. Had a little bit of a consolidation phase, but on a relative basis, outperforming above its rising 50- and 200-day moving averages. So if you think about some of the commentary you got from Taiwan Semiconductor and their earnings, pointing to, you know, low to mid 20% revenue growth and calling a healthy year for the semiconductor space. Some pretty positive read throughs on the earnings front as well. So, like what we see within the semiconductor space right now.

Jeff Buchbinder:

Yeah, based on consensus estimates, Nvidia is about half of the tech earnings for this quarter. So I think tech earnings are expected to grow around 16, 17%, and I think, without Nvidia, it's more like eight to nine. So Nvidia is really a big mover, big earnings mover, and will be key certainly to how well tech does. Actually, that's one of the Mag Seven that reports later. So really good.

Adam Turnquist:

Yeah, a closely watched one, of course, and in terms of the more the fundamental picture, this is a chart that I wanted to show. Just the global chip sales turning positive for the first time since the summer of 2022. This is data from the Semiconductor Industry Association, and you can see just in November, that's the most recent print. Year over year sales were up five, just over 5%, for global chip sales and that's a pretty good signal. You can see how when they do turn positive, they tend to stay positive for these periods of a positive growth cycle. And we actually back tested this. So if you look at the previous times when this cycle, we'll call it, turn positive, we looked at how the SOX semi index performed over the next 12-months, it was actually higher on average by 28% over that 12-month period, and eight of those nine periods were positive. Of course, a lot of people look at semiconductors as more of a leading economic indicator so we looked at performance for the S&P 500 as well, and the index was up about 10% 12 months later during each of these positive, or transitions from a negative to positive, sales cycle for semi. So again, another, I think, positive read through for this growth cycle and semiconductors and what that means for the broader market.

Jeff Buchbinder:

Yeah, if we get double digit returns out of semis this year, I think there's a good chance we're going to get the same out of the S&P 500. So that's really, really interesting. And, you know, the NVIDIAs of the world, the ones that are more, you know, better positioned for AI, certainly are telling us positive things now. But you've also got, you know, Intel and Texas Instruments where the results, the outlook, disappointed last week. But those are certainly different types of chips, you know, more industrial chips, auto chips, things like that, that certainly are not as hot as AI. So, you know, all in all things look pretty good there, but there's certainly going to be you know, winners and, maybe not losers, but big winners and medium-sized winners and maybe small winners. How about that?

Jeff Buchbinder:

So thanks for that, Adam. A real important group to follow, no doubt, and I'm sure many active investors listening are playing semis at times. So let's turn to the bond market. This is still a really important, you know, driver of stock market performance, right? It obviously matters for bonds, but you know, this stock market's still interest rate sensitive. You've got that in the lower panel. So we talked about rates over the last couple of weeks, saying that maybe the big move down is, kind of, you know, it's kind of played out when we were down at like 3.7, 3.75, or so, 3.8. Now we've moved back up as the market has priced out Fed rate cuts, right? I think kind of moving from like 6.5 to five, maybe, give or take. So where do you see rates going based on what you see in the charts here, Adam?

Adam Turnquist:

I think you nailed them. In terms of the big move lower, I think we have seen that. I don't expect yields to have another leg lower, comparable at least to what we've witnessed in the fall. But technically here, we've had what I would consider a relief rally for yields off oversold levels. That was really starting in the beginning of December, we'll call it. We reversed this shorter-term downtrend, and now we're seeing that relief rally stall out at a key area of overhead resistance, right around the 50-day moving average, call it kind of this 4.15 level. And now we're back right around the 200-day moving average at 4.08. So keep an eye on that level. I think we start breaking down there. We could go and retest those lows that we witnessed. That, kind of, 3.75, 3.8 level for yields but when we look at it technically, I think upside risk will likely be capped, call it right around 4.35, as a reminder that goes back to those October 2022 highs. There's a key retracement level in that area, and then, of course, the macro environment and we're talking about a narrative that's going from rate cuts to rate, or sorry, from rate hikes to rate cuts. Still getting used to that. I think it's going to be pretty hard to really make the case here for materially higher yields. In terms of the implications for the equity market, I think the best case for the 10-year is just a consolidation phase. More of a sideways trade for the 10-year, call it, you know, maybe we'll use Lawrence's 3.75 to 4.25 range for year end. I think that makes sense technically. And when you look at how equities performed when we were in a range from, you know, October 2022 to the summer of 2023, we basically traded sideways for the 10-year. Equities did quite well. It was really when rates started breaking out through 4% and taking off from there, that's when you had those correlations break down and turn decisively negative. Don't expect that again for 2024.

Jeff Buchbinder:

Yeah, we wrote in our 2024 Outlook that we just wanted rate stability as a potential driver of higher stock prices. So we're getting some of that but maybe not quite as stable as we would like because we have, you know, ticked back up what, 30 basis points or so off of the recent low. So stability is still good, but maybe drifting lower as more evidence that inflation is falling comes through, and then maybe we hear from the Fed this week that they are getting ready for the cut. We'll have to see. So busy week this week, Adam. You know, we don't think we're going to get a March cut from the Fed anyway. So, and frankly, the extra, you know, shipping costs, companies are having to pay to go around the southern tip of Africa and avoid the Red Sea and the insurance costs and all of that that is probably going to cause the Fed to maybe, you know, think twice about a March cut if they were thinking about it anyway.

Jeff Buchbinder:

So we probably won't get too much out of the Fed, maybe just a nod to that element of the inflation picture but otherwise, it's just going to be kind of wait and see. Data-dependence. The jobs report, you know, we've seen slowing job creation, which is good. We've seen fewer job openings, which is good because it takes down wage pressures. Wages are still rising nicely, but they're rising at a slower rate, which sets the Fed up for a cut. So we think we'll see, you know, continued trend toward slower job gains but you're probably not going to see the unemployment rate move much. I think that's probably the biggest data point of the week besides the Fed. But the ISM is always interesting. We've seen evidence of a pickup in manufacturing recently, so maybe we'll get a little bit better ISM manufacturing number than the consensus expects. I'm particularly interested in that because of the relationship between manufacturing and earnings. And then, of course, we're always watching consumer confidence. Anything else here, Adam, that you think folks should be watching or anything you want to add to the things that I've shaded here?

Adam Turnquist:

No, nothing major. I think, as you alluded to, kind of a no news is good news coming from the Fed this week when we think about the implications for further hikes or further cuts. And then, of course, just the employment picture overall. We have jolts coming out on, I think that's tomorrow actually. And then obviously the payrolls data, if it's going to be kind of this slowing but growing labor market. It's a pretty tough Goldilocks scenario to really kind of land that so I think it'll be an interesting week in terms of data, not to mention all of the earnings as well.

Jeff Buchbinder:

Yeah, this is a huge week for earnings. I mean, we still think, excluding those bank charges, we can get maybe four or 5% earnings growth, but not without big tech getting us there. So this is the most important week. It's the most market cap reporting earnings this week of any week during earning season. And it's the most important in terms of where the most earnings growth is coming from. So Microsoft, Alphabet, Apple, Meta, Amazon all this week, I think Microsoft and Alphabet are Tuesday and the rest of Thursday. So we'll be watching that while we watch the Fed and we wait for the jobs report. You know, based on the revisions and based on, you know, estimates have been rising for the tech and tech-related areas of the market for the past several months. And we know how powerful the AI trend is.

Jeff Buchbinder:

And you know, just in general, we've had, I mean, you saw it in Netflix, obviously Netflix is a different business than, than these, but you've just seen a lot of strong performance over the last few months from digital businesses, right? Internet businesses the mega cap techs. That's where a lot of the spending is going. And so we expect that trend to generally continue hard to trade these. We don't know if expectations are too high, but the business trends, the business fundamentals really across all these companies, we think, look, look pretty good. Maybe save Tesla, which is clearly seeing a slowdown in in their EV business. So with that, let's go ahead and wrap. Thanks Adam, for walking us through those charts and even weighing in on some, some fundamentals. I've always said you're a lot more than the technician.

Jeff Buchbinder:

Well-rounded strategist no doubt. So thanks for joining today. Really good discussion. Lot of good topics to hit and a lot of things to look out for this week. I guess I'll end first by saying thank you everybody for, for listening. As always, we appreciate your support of Market Signals. And I'll also say to you, Adam, I'll see you tomorrow. Yeah, we're both flying. Looking forward to, we're both flying to the same place for an LPL Research shindig in Charlotte. So looking forward to seeing you and the rest of our big and growing team. I've lost track of how many people are on our team, but <laugh>, it's a lot now, a lot more than it was a few years ago which is great. So looking forward to that. Everybody. Have a great week. Take care and we'll see you next time.