What we learned in Q3 about bullish, sensitive equity markets

It’s perhaps been the story of the year, and certainly the story of Q3, that despite big scary headlines, corporate earnings come up solid and equity markets keep on grinding higher. Reflecting on the earnings reported in Q3 and the market moves from July through September, Philip Petursson saw a US economy and US market headed in the right direction, opportunity in ex-North American equities, and lots of reasons for optimism.

That is not to say that Petursson, Chief Investment Strategist at IG Wealth Management isn’t also cognizant of the risks present on the market. From increasing investor sensitivity to macro shocks, issues of concentration risk, and the challenges of diversified investing when indexes skew towards mega caps, Petursson outlined the areas that advisors need to be aware of now and what they can do to contextualize this positive but sensitive market environment for clients.

“Given the strength that we've seen since the lows of April. Investors are going to be hypersensitive to anything. And it didn't need to be the U.S. and China. It could have been anything else. We never know what it's going to be,” Petursson says. “There are going to be sensitivities out there. We're hearing more and more people ask, if we are in a bubble, whether it's an AI bubble or the market hitting an all-time high. People are almost looking for a reason to pull back a little bit, to trim a little bit.”

Despite the fears and sensitivities of some investors around the market, Petursson also notes that Q3 gave us reasons for optimism, even on US markets which are so often derided for their expensive valuations. Companies like Nvidia, for example, have been able to compress their multiples with significant earnings beats that speak to a wider environment of corporate growth in the US. He highlights the fact that the overall price to earnings multiple of the S&P 500 is roughly where it was at the start of the year, despite some significant price appreciation on the index. Petursson likens this moment to the 1993-1995 stretch when valuations were high but rather than resulting in a market downturn, markets traded somewhat sideways as earnings growth continued. Going forward, he sees a more flat trajectory for US markets ahead.

While many names, like Nvidia, are making significant amounts of money and posting huge earnings growth, other key names have been rewarded more for what they spend than what they earn. The so-called ‘hyperscaler’ companies like Microsoft, Alphabet, and Meta have all seen their share prices appreciate on the back of huge investments in data centres and AI software buildouts that aren’t necessarily translating into new revenue streams just yet. These companies are still earning via other streams, but their connection to AI has driven much of their growth. At the same time, Petursson notes that we’ve seen deals between many of these names that result in hundreds of billions being circulated between them, offering reasons for investors to better scrutinize these names and question whether some of the AI expectation has become a bubble.

“I think it's naive and irresponsible to say, no, we're not in a bubble. We don't know in truth. You never know until after the fact,” Petursson says. “With the amount of money that we're talking about and the valuations that go along with it, could the market be stretched? Yes, it could. Could we say that we're seeing bubble-like symptoms out there. Sure, we could.”

He notes that share prices for companies like Costco and Wal-Mart have jumped significantly on the back of announced AI deals. Petursson questions, though, whether these retailers should be suddenly valued like an AI company when their underlying business model won’t change just because of some new AI automations in their workflows.

Petursson also notes a somewhat difficult dynamic around index investing in a highly concentrated US market. With a few mega-cap technology names now comprising upwards of 30 per cent of the market capitalization of the S&P 500, passive index investing becomes a self-reinforcing trend for these companies. As more money flows into index funds, even those ostensibly holding 500 companies, a significant portion of that money goes into a few US tech mega-caps. The risk, Petursson says, is that if investor sentiment turns on these companies it can drag the whole index down, causing a shift away from those index products which creates a vicious cycle. The answer, in his view, lies in meaningful diversification beyond just passive indices.

Petursson sees both upside and risk management in markets outside of North America. He explains that international equities are expected to generate similar earnings growth to US stocks, but from lower valuations. He adds that the AI theme is not exclusively US-domiciled, and that the efficiency improvements AI is offering to US companies are being realized globally as well. Despite a fear of missing out on another big US equity run, he sees more upside abroad.

Advisors may have to do some of the work to temper both the fear of missing out and the fear of a bubble that seems to be conflicting in many investors’ minds. Petursson says that advisors need to begin by dispelling the fear of all-time highs and driving home the role of earnings growth in the market.

“All-time highs tell us nothing about board performance. It doesn't say things are going to be great, doesn't say things are going to be bad. It actually is the same as any other day in the marketplace. So why the markets are where they are today is because of earnings growth,” Petursson says. “Valuation tells you nothing about short-term performance. Respect it, understand it, but don't fixate on it… Stocks can stay expensive, as we've seen in the late 90s, for years before you hit that tipping point. So don't shy away from the opportunity set that we have today. At the same time though, remember we cannot predict risk. All we can do is manage it. And the best way to manage risk is to diversify.”