Summary
SPDR S&P 500 ETF Trust (SPY) has generated a 20.25% total return in 2023 so far.
We share three reasons why we think that SPY could be on the verge of a bear market.
We also share the one remaining hope that SPY has to continue pushing higher in the near term.
The SPDR S&P 500 ETF Trust has been on a tremendous run so far in 2023, generating a very impressive 20.25% total return for shareholders so far:
That said, based on at least three factors that we will examine in this article, we believe that SPY could be on the cusp of a bear market:
#1. SPY Is Significantly Overvalued
First and foremost, SPY appears to be significantly overvalued based on a wide variety of metrics. While it is certainly possible for the stock market to remain overvalued for a lengthy period of time, the odds are certainly stacked against SPY shareholders at current valuations.
As the chart below indicates, SPY's forward P/E ratio is currently at 19.57x, sitting nearly a full standard deviation above its 25-year average:
Given that the Federal Funds Rate is near its highest levels over that span, SPY's valuation looks even more bloated:
Other valuation metrics that further support the case for SPY being overvalued include:
The Buffett Indicator which is 1.6 standard deviations above the historical trend line.
The S&P 500 Mean Reversion model which is about 1.4 standard deviations above the historical trend line.
The Yield Curve Inversion model which is currently very inverted, sending a flashing red light for markets and the economy.
#2. A Recession Is Likely Imminent
The dramatic yield curve inversion is enough of a warning sign that a recession is highly likely. However, there are other reasons to be concerned that a recession could be just around the corner.
One major warning sign is that American manufacturing activity is at its lowest level in three years, meaning that this important sector of the economy is already in a recession. The ISM Manufacturing Purchasing Managers' Index fell to 46 in June from 47.1 in May, marking the eighth consecutive month of contraction in the manufacturing sector. Moreover, the new export orders index dropped from 50 in May to 47.1 last month. Order backlogs also increased, indicating that there is a lack of new demand and that businesses are working through existing orders. Moreover, the Prices Paid index, which measures average prices paid by manufacturers, declined to 41.8 in June, and the employment index dropped to 48.1 as manufacturing jobs declined.
Another warning sign of a potential coming recession is that global earnings have started to decline on a year-over-year basis. If this pattern persists, we will almost certainly find ourselves in a global recession shortly.
A third warning sign is that China's economy is clearly slowing down. Given its vast size and significant impact on the profitability and supply chains of many of the top holdings in SPY such as Tesla (TSLA) and Apple (AAPL), a Chinese recession could push the global economy into recession with an outsized impact on SPY.
#3. SPY Is Running Out Of Catalysts
Finally, in addition to being significantly overvalued based on numerous models and facing likely macroeconomic headwinds in the near future, SPY is also running out of catalysts.
The strong run SPY has been on year-to-date has largely been fueled by the artificial intelligence boom. However, as the graphic below illustrates, SPY's top seven holdings - AAPL, Microsoft (MSFT), Amazon (AMZN), NVIDIA (NVDA), Alphabet (GOOG)(GOOGL), Meta (META), and TSLA - are all considered to be significant A.I. plays.
As you can see in the chart below, these holdings - which currently make up a whopping 27.73% of SPY's portfolio - have all roared higher this year, significantly outpacing even SPY's strong performance in the process:
What this means is that the single biggest catalyst for SPY at the moment - artificial intelligence - has largely already been priced into SPY's holdings. In fact, a case can be made that the artificial intelligence-related hype has probably already been more than priced in and is indeed in a bubble.
With a recession likely hitting the economy in the near future and its largest constituents already trading at nosebleed levels due to as of yet largely unproven hype over artificial intelligence, SPY lacks any meaningful catalysts to push it higher.
One caveat here is that if the Federal Reserve indeed pivots and begins to cut interest rates in the near future - especially if done alongside a true soft landing for the economy - it could push SPY a bit higher. This is going to be quite difficult to navigate, however, because Core CPI remains elevated relative to historical levels and the Fed's 2% long-term target, though it is falling:
With the real estate component of Core CPI expected to drive the number lower in H2 2023, there is some hope that the Fed's 2% inflation target will be reached by late this year. This could then free it up to begin cutting interest rates sometime over the next 9-12 months and potentially stave off a meaningful recession.
However, if this narrow window for cutting interest rates is not achieved, the wall of commercial real estate debt maturing in the coming years will begin to weigh heavily on the economy and could deliver the death blow to the current weak expansion. Moreover, if inflation outside of real estate remains stubbornly elevated and/or real estate inflation spikes again in the wake of the Fed attempting to cut interest rates, SPY will likely be in for a world of hurt.
Investor Takeaway
SPY has been a great place to be invested so far in 2023 as it has recovered from a pretty weak 2021-2022 when it delivered a meager 2.63% total return CAGR to shareholders.
However, the path forward to sustained high returns is less clear given that the A.I. frenzy is now pushing its way into bubble territory for SPY's very largest constituents, the overall index appears quite overvalued, a recession seems more likely than not to occur in the near future, and the Federal Reserve has a rapidly shrinking window during which to finish its fight against inflation and begin to roll back its restrictive interest rate policy.
With all of these headwinds blowing against SPY, we think there is a real chance that it could be on the cusp of entering another bear market and rate it a Sell accordingly. Instead, we are buying high-quality, underfollowed, defensive dividend stocks which should weather a recession well and are now trading at compellingly discounted prices as much of the market's capital has poured into artificial intelligence names this year.
