WARNING SIGNS FOR THE U.S. BULL MARKET
On occasion we are told we are overly optimistic investors – maybe even perma-bulls. We are not perma-bulls but do tend to be very optimistic. Our position remains that optimistic investors do better than pessimists. After all, more good things than bad occur in our economy and markets. That is the reason the size of U.S. GDP and the stock markets continually hit new highs. Yes, we have recessions and bear markets, but that is part of capitalism.
However, now is a time, in our view, to turn cautious on stocks in the near-term for the reasons listed below. We will address the state of the U.S. economy, IPOs, and market internals. Let’s start with the economy:
The three pillars of the U.S. economy we will be reviewing are residential real estate, consumer consumption, and the AI infrastructure buildout.
First, residential investment continues to be in the penalty box. This is relevant because housing accounts for about 16% of GDP – not insignificant by any measure. Too high mortgage rates and too low affordability have left little catalyst for the housing market to be additive to economic growth.
Second, consumer consumption is solid but there are cracks in this thesis. The K-shaped economy is alive and well. There is plenty of evidence that lower-income consumers continue to get squeezed while the upper incomes continue to spend away. The majority of consumption is typically driven by the upper incomes so this relationship can persist and remain supportive. Let’s look at the source of this strong retail spending and overall consumption: consumer incomes. One statistic that haunts us is that real consumer disposable income is running at a growth rate of 0% on a year-on-year basis. How can this support continued consumption growth going forward? Without an increase in real disposable income, consumption may slow which will impact corporate earnings. And then add in the energy tax in the near-term. Without higher wages, where does a sustained increase in inflation come from outside of tariffs and rising energy prices. Rising prices and falling real wages leads to demand destruction. This is not inflationary. Maybe the inflation hawks looking for a Fed rate increase have it all wrong. Without the wage catalyst economic growth is unlikely to reaccelerate. If the consumer is suspect, that leaves the AI theme as the primary engine for growth.
Third, many investors think AI and its related infrastructure buildout is the key to economic growth for the foreseeable future, but have questioned the overreliance of U.S. growth on the AI boom. As long as the hyperscalers keep spending, the music keeps playing. What happens if/when the AI cycle turns? The odds will certainly rise of a significant slowdown or recession as the wealth effect evaporates. But for now, if we use the hyperscalers’ capex estimates as a leading indicator, things are solid. Purchase commitments are good as far out as three years. Sure, this can change but the order books appear solid.
Next, IPOs: Equity markets are turning their attention to the supply of shares coming soon to the markets. Historically, big increases in the supply of shares has been either in dire circumstances (recapitalizations in 2009) or at peaks in market manias (2000, 2021). For now, gross issuance is still relatively low as a percentage of market cap but with three monster IPOs lined up, gross issuance is set to rise materially.
The three monster IPOs are SpaceX, Open AI and Anthropic. All three will eclipse the previous largest U.S. IPO (Meta Platforms, 2012, $81.2 market value). Space X is projected to be valued at $1.5 trillion to $2.0 trillion (yes, trillion); Open AI and Anthropic at just under $1.0 trillion.
As an aside, we do not participate in IPOs. Shares are generally overpriced by the smart money that is selling (SpaceX will trade at about 83x sales). After a typical spike on their first day of trading, IPOs often struggle and underperform the market averages (source: Wall Street Journal).
The big question is whether this flood of new shares to the market is a sign of the end of the bull. We don’t think so as these three firms are pillars of the current industrial revolution but we will be watching closely what companies follow.
Finally, many market internals should be viewed with a cautious eye. In no particular order:
Although earnings growth has been fantastic with future estimates still rising, it has been extremely lopsided (top heavy). A broad basket of AI names earned 38% more than last year, energy stocks grew earnings by 62% in the latest quarter year-over-year (source: Bespoke Investment Group). The rest of S&P 500 companies are expected to grow earnings 11% in 2026. This extremely top-heavy dynamic in earnings is not necessarily unsustainable but should be watched. The market is vulnerable to narrative shifts in the earnings macrotheme.
Also, breadth has been very narrow in the last two months for the S&P 500. May was a month when the major indexes continually hit all-time highs but the daily advance/decline line was often negative. This shows the rally was limited. The market was led by a handful of tech/AI names but many stocks were flat or down. Only 20% of index names actually outperformed the index, a very weak number.
Lastly, are we seeing typical late cycle behavior? Tech stocks have rallied 36.1% in the last two months. We haven’t seen a move like this in tech since the first two months after the Financial Crisis bottom. Tech stocks now account for 37% of the S&P 500 index weighting, a new high. And there has not been a hotter sector of the market than semiconductors which now account for a record 18.7% of the index compared to 5% five years ago.
In conclusion, we are not giving up on the bull market. There are positive developments daily, but a healthy dose of reality is necessary for solid analysis. While this bull market is now stronger and longer than average, there is plenty of precedent for it to continue. But, in our view, expectations should be tempered from here, at least in the short term. We always stay fully invested so we are not reducing our equity ratios. But our analysis does impact the types of stocks we will buy going forward. If we had it our way, we would like to see a slow and steady trend higher for the next few years without any major boom or bust.