Is 2023 a Bull Market, or Stock Market Bubble?

This week, the S&P 500 hit 4,600 points, which is now only a few percentage points away from its all-time high back in January 2022. Yes, with all the doom and gloom and discussions of recessions, banking crises, high interest rates, low savings rates, commercial real estate problems, and so on over the past nine months or so, the S&P 500 has gone on one of its steepest ever rallies, rising almost 30 percent.

There was an expectation that we'd be entering a recession by now. There is strength in this economy and an end in sight to the rate hikes. The S&P 500 and the NASDAQ each hit new 52-week highs, and we're about five and a half to six percent off of all-time highs. That's kind of the opposite of a recession.

We're currently being asked: Is the new high going to happen? Are you looking at this as a new bull market? Though, yeah, we're in a secular bull market. A new bull market. We have entered a new bull market. But why is this happening? Well, it boils down to four points, the biggest being what's going on with inflation and interest rates.

Over the past few years, we've seen inflation really run hot in the U.S., peaking at around nine percent a year ago. However, over the last 12 months, we've seen inflation cool a lot, with the current headline inflation rate at just three percent, which is actually quite close to the Fed's annual inflation target of two percent. Now, while we can argue that core inflation, which excludes volatile food and energy segments, is still at 4.83 percent, the sentiment from the Federal Reserve does seem to be changing over interest rate hikes.

Of course, by raising interest rates, you cool the economy and help to lower inflation. But now that the headline inflation rate has lowered to just three percent, we've seen the Fed's sentiments start to shift, which is making investors increasingly optimistic. While the Fed did decide to raise rates again by 0.25 percent last week, Jerome Powell indicated that the Fed is indeed starting to think about shifting their monetary policy.

“We've raised the federal funds rate now by 525 basis points since March 2022. Monetary policy, we believe, is restrictive and is putting downward pressure on economic activity and inflation. I would say it is certainly possible that we would raise funds again at the September meeting if the data warranted. And I would also say it's possible that we would choose to hold steady at that meeting. We're going to be making careful assessments, as I said, meeting by meeting.”

Since this downtrend in inflation was established, this has caused a lot of investors to regain optimism as they anticipate the possibility of a pivot point where monetary policy trends away from raising rates and starts leaning the other way. If this were to happen, that's good news for the consumer, it's good news for economic growth, and thus it's good news for corporations that make up the stock market.

While the economy and the stock market are, of course, two separate things, interest rate changes do have a strong effect on stock valuations. This is Warren Buffett explaining how this works: "Interest rates are to asset prices, you know, sort of like gravity is to the apple. When there are very low interest rates, there's a very small gravitational pull on asset prices."

And we have seen that getting played out. I mean, people make different decisions when they can borrow money for practically nothing. Interest rates power everything in the economic universe. Long story short, interest rates are the gravity on the stock market. Low interest rates make it easy for valuations to rise, while high interest rates make that a heck of a lot harder.

So while interest rates remain high for the moment, the big money is starting to shift their money back into the market as they anticipate that change in monetary policy. That's by far the biggest contributor to the stock market rally. But another effect we're seeing right now is the weakening of the U.S. dollar.

This doesn't directly impact the stock market, but it does directly impact the earnings of U.S.-based companies that make up the S&P 500. A weak dollar improves the value of revenues generated outside the U.S. As these massive corporations bring their international revenue back to the United States, they get more U.S. dollars for it, which helps improve their earnings. This effect can be quite strong for the S&P 500 because the index is home to some of the largest global companies.

In fact, approximately 30 percent of S&P 500's revenue comes in from overseas, according to analysts at Evercore. So ever since October of last year, as the U.S. dollar index has been falling, the companies of the S&P 500 have been enjoying this effect. Of course, over the previous years, we've actually seen the complete opposite. The U.S. dollar has been very high versus other currencies, meaning that as the big U.S. behemoths drag their international revenue back to USD, they were getting less dollars for the same business.

But long story short, today, as more and more big S&P 500 companies report earnings for the second quarter, they will likely get a bit of a boost from the foreign exchange impact. With large global companies like Apple, Microsoft, Amazon, Nvidia, Tesla, Google, and Meta occupying over a quarter of the weight of the whole S&P 500, it's quite likely that these additional FX related earnings could have an impact on the index as a whole.

Although one thing to remember is that year-over-year comparisons of corporate earnings will likely still be worse off, as the U.S. dollar index is still higher than what it was 12 months ago. But that is reason number two as to why the stock market is on this rally. Another reason is quite simply growing investor confidence, because some economic indicators actually look okay. Unemployment is very low.

The Federal Reserve just noted that the current unemployment rate is 3.6 percent in the U.S., and over the last three months, the U.S. has averaged 244,000 job gains per month. Consumers are still spending as much as they ever have, which is a good sign for corporate profits. Beyond that, Bloomberg noted recently that even things like gross domestic product, new home sales, and even durable goods orders are coming in above forecasts.

You have the International Monetary Fund revising their global growth expectations 0.2 percent higher for 2023 and the global inflation estimates down by 0.2 percent. There are some economic factors that are trending in a positive direction, and that gives investors optimism, causing them to once again buy stocks. But of course, with that said, we can't forget the final reason as to why the stock market is rising: hype.

People are excited. It sounds dumb, but it's true. Psychology is a big factor, and the news has once again proved that investors are getting frothy—perhaps more so than they should. How about this one? Analysts at Bank of America recently declared the bear market officially over, noting that historically, after rising 20 percent from a low point, the S&P 500 has continued to rise over the next 12 months more often than not.

I mean, that's not a stat that should influence decision-making, right? But that's what you're seeing in the media articles. What about the great buzzwords of 2023? Artificial intelligence has fueled a lot of this stock market rally. Nvidia stock, which I made a video about very recently, is up over 200 percent for the year and now sits at a one trillion dollar market cap, with just two billion dollars in quarterly earnings.

Funnily enough, it was in November of 2022 that ChatGPT was released, which coincides perfectly with the start of the stock market bull run. Since that time, we've seen all the big tech stocks jump in on the AI bandwagon, and they've all shot up. We used to get excited about the FAANG stocks; these days, it's apparently the Magnificent Seven: Apple, Google, Microsoft, Tesla, Nvidia, Meta, and Amazon.

Apple and Google are up 55 percent since late last year. Amazon's up 50 percent. Microsoft's up 57 percent. Tesla's up 144 percent. Meta's up 235 percent. Nvidia's up 300 percent. These are companies jumping on the AI hype train, and as investors have done the same, their stock prices have skyrocketed.

Why this is such an important factor in the recent stock market rally is because, as we've discussed earlier, the S&P 500 is very top-heavy. These seven companies account for 27 percent of the entire S&P 500. Yes, seven companies are 27 percent and 493 companies account for the other 73 percent. These seven tech behemoths have a significant impact on the whole index.

So if investors are excited about just these seven companies, the S&P 500 as a whole will rise quite substantially, and that's exactly what's happened. There is a problem with this, however, because the S&P 500 is very commonly used as the benchmark of the entire U.S. stock market. What this means is that you can have literally 98.6 percent of the top 500 companies doing average, but if that remaining 1.4 percent is thriving, it gives the illusion that corporate America is thriving when maybe that's not quite the case.

Again, long story short, a lot of the rally we've seen over the last ten months has boiled down to the hype surrounding AI and excitement around what these seven tech businesses are doing in the field. So, they are the four key reasons why the stock market is showing strong results while the broader economy is showing mixed signals.

But with that said, what do we as long-term value investors take away from this? Well, if I'm honest, in these sort of situations, it's usually best to not make any bets implicitly based on the current market conditions. The best investors in the world—the Warren Buffetts, the Peter Lynches, the Monish Pabrais and so on—would almost certainly remind us right now to block out the macro and instead focus on individual businesses and assess them from the bottom up.

Seth Klarman was talking about this literally in my most recent video: "As an investor, I've learned to try to be focused on things that actually are going to move the needle for me and my portfolio. So, I try to focus on bottom-up individual situations—stocks, bonds, real estate transactions—and I don't spend a lot of time thinking about things where I think the answer is pretty imponderable."

I've even asked Guy Spier about this in the past, and he's had exactly the same thing. Should somebody that's interested in getting started with investing—value investing, Buffett style investing—be paying attention to macroeconomics? Does it play a role in your investing, or should it just be blocked out from the decision-making process?

"There's a very easy and simple answer to that, Brandon," he says. "You absolutely should block it out and just forget that it was even there and realize that macroeconomics is important from a macro perspective, but we're operating on the scale of our own personal savings or the savings of us and our investors. We're operating on it at a completely different scale, where it kind of doesn't matter for us. What we're trying to do is we're trying to own a piece of the productive economy.

Maybe another way of looking at it is if you're a mouse or if you're an ant walking around amongst elephants, you absolutely care where the elephants are and you care where they step, and all of those things. But at the end of the day, you know what you need to do. You need to work on building your nest. You need to work on gathering food. It's just such a different scale that it's not going to affect what you need to do on a daily basis, and you shouldn't allow, in that analogy, the movements of the elephants to affect what is your daily task, which is to say, own a slightly larger proportion of the world's productive assets."

So overall, while it's always intriguing to watch what's going on in the stock market, how the S&P 500 is moving, for value investors, keep your eyes firmly within your circle of competence and try to block out the macro pressures. Or if you're a passive investor buying the S&P 500 on a dollar-cost averaging plan, just keep on keeping on.

But with that said, please let me know how you are investing right now. Are you seeing opportunities out there? Does the macro environment concern you? Definitely let me know, and I'll follow up with you guys down in the comments. But apart from that, please like the video if you enjoyed, subscribe to see more, and I'll see you guys in the next video.