35-year market vet David Rosenberg warns the stock market's rally features distortions that were glaring during the tech bubble — and lays out his plausible scenario for a crash

  • Famed economist David Rosenberg is concerned about the outsized role that a few big-tech companies are playing in lifting the stock market to all-time highs.
  • He says their tech bubble-like valuations, and the underperformance of sectors that would be thriving during a broad-based economic recovery, portend a reversal for the broader market. 
  • He further laid out a plausible scenario that places these mega-cap tech stocks out of favor with investors. 
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With stocks back at all-time highs, it appears that the manic days of March have been fully relegated to the annals of market history. 

But not everyone is ready to pop the champagne on a either a new bull market in stocks or on a new economic cycle of growth that would help extend the gains.

David Rosenberg, the famed economist and founder of Rosenberg Research, remains cautious as ever, even as bulls tally their post-crash gains. In his view, the foundations of this rally are unsustainable, and in some ways reminiscent of preconditions to the early-2000s tech implosion. 

"The point I'm making is that an ownable bull market is premised on fundamentals and valuations. We don't have those," he said recently on a Palisade Radio interview.

He continued: "We have the technicals; True. We have momentum; It's true. But the most dominant force right now is liquidity — and so this is a liquidity-driven bull market."

The liquidity is being provided by one other than the Federal Reserve, he said. While its crisis response is supporting credit markets directly, it has also engendered confidence in investors who wish to earn higher income from riskier assets amid historically low bond yields. 

Consequently, stock-market valuations now rival those that prevailed at the peak of the dot-com craze, Rosenberg noted.

An 'egregious' extreme

A closer look at the best-performing stocks — the mega-cap tech names thought to be the biggest beneficiaries of physical distancing — raised more concerns for Rosenberg about the sustainability of this rally.   

Their outperformance as a group of high earnings-growth stocks relative to issues that are considered cheap is one concern. So-called value stocks that make up the latter category now account for 20% of the S&P 500. For context, they historically make up about 45% of the market, Rosenberg noted, adding that value now constitutes half its share of the norm. 

"The most egregious this extreme got in the dot com bubble in the late 90s was 30%," Rosenberg said in a recent note.

He added, "I don't know what causes the mean reversion trade or when it will come, but it will come as it did in 2000, 2001 and 2002. As Herb Stein famously said, anything that can't last forever, won't."

Amid this performance bifurcation between large-cap growth and the rest of the market, Rosenberg highlighted frailties in parts of the market that are not dominating returns. 

Energy, financials, industrials, and transports are all market sectors that would benefit from an uptick in economic activity and consequently, higher inflation. However, they are still down year-to-date.

And even though the S&P 500 is soaring, a version of the index that does not weight companies by market cap is still down by about 6% from its pre-COVID-19 peak.

This signals that participation in the rally is low. It is possible to account for this trend by observing that the best-performing stocks are those geared towards the work-from-home economy. But Rosenberg's retort to that argument is that it actually shows a true and broad-based economic recovery to pre-COVID levels remains at bay.

With all this in mind, he took a stab at guessing what may turn the tides for the market. One plausible scenario is the sudden return of inflation, which would increase bond yields and rein in the multiples that investors are willing to pay for high-growth stocks. This scenario would weigh on the broader market, given the heavy weight of growth stocks on performance.

"The situation is fluid — the best strategy, if you have ridden the growth wave in recent months, is to take some chips off the table. Bulls win; bears win; pigs get slaughtered," he concluded.

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