Since the Federal Reserve began its aggressive rate hike cycle, US stocks have repeatedly hit new highs amid a chorus of pessimism, which is unexpected. What does this mean?

Recently, Richard Bernstein, a Wall Street veteran and famous columnist, wrote that although the Federal Reserve has raised benchmark interest rates sharply since early 2022, the excellent returns of highly speculative investment strategies prove that this most aggressive round of interest rate hikes in nearly 30 years has not been able to fully absorb the excess liquidity in the financial markets.

In other words, the financial market is already full of bubbles.

In Bernstein's view, bubbles lead to capital misallocation, flowing into unnecessary assets (such as cryptocurrencies and meme stocks), rather than truly contributing to productivity. This will become the source of future actual asset inflation. In fact, since the dot-com bubble in 2000, the US PCE price index has reached a peak of 5.6%.

Behind the strength of blue-chip stocks, storms are brewing.

Bernstein added that the misallocation of capital is also manifested in a "strange" phenomenon in the current market: although credit spreads have repeatedly narrowed, large cap stocks still outperform small cap stocks thanks to the boost of the technology sector's "Fabulous Seven."

But according to historical conventions, because small-cap stocks have smaller size and larger leverage, they are more sensitive to economic and profit cycles. Therefore, when corporate profits improve overall, small-cap stocks often outperform large-cap stocks and credit spreads narrow. Conversely, large-cap stocks tend to perform better than small-cap stocks, and credit spreads widen. Obviously, speculative behavior in the high interest rate environment of the past two years has significantly distorted this long-existing market relationship.

It is clear that the speculative behavior in the past two years in the high interest rate environment has significantly distorted the long-existing market relationship.

Bernstein warns in the article that the misallocation of capital again is the harbinger of rising inflation, and a financial storm may be brewing, and the Federal Reserve seems to have not yet learned from history.

The "triple facts" brought by the misallocation of capital

The extreme differentiation may indicate or predict three situations:

First, the degree of improvement in corporate profitability is underestimated.

The article stated that behind the extraordinary performance of the "Fabulous Seven," the market may have overlooked the fact that corporate cash flows are widely improving, and the tightening of credit spreads also reflects this. Relevant data shows that about 160 companies in the S&P 500 index currently have achieved profit growth of more than 25%.

Secondly, although the current stock market's uptrend is highly concentrated, it is unlikely to trigger another Great Depression.

Goldman Sachs has previously issued a warning, believing that the high concentration of stock market gains in the current US market seems to be replaying the crash crisis of the 1930s, but Bernstein believes that considering the acceleration of corporate profitability and the healthy performance of the banking system, this possibility seems to be small.

Finally, cyclical stocks are expected to rise.

The article pointed out that excess liquidity may be driving speculation in the stock and fixed income markets. If this is the case, those non-defensive sectors (such as emerging markets and small-cap stocks) may become investors' "safe haven" when the volatility of the current stock market "leader" intensifies. Historical data shows that after the dot-com bubble burst in 2000, although the US stock market fell into a "lost decade," energy stocks, commodities, emerging markets, and small-cap stocks performed well.

The article explained that these sectors mainly benefited from capital withdrawn from technology stocks and profit growth promoted by inflation after the burst of the bubble.

Editor/Emily