Howard Marks is right. This bull market just might have legs. Big tech continues to spend on artificial intelligence and interest rates are expected to go down. As long as the economy weathers the tariff transition, 2025 could prove more akin to 1997 — a few years before the dot com tech bubble burst -- than 1999. Here's how.

• Valuation has never been a good timing signal. An overvalued market can become more overvalued as the Japanese witnessed four decades ago.
• What matters in the meantime is economic and earnings growth that beats expectations — even if it’s not as great in and of itself. 
• A less restrictive rate environment is also helpful to ensure the economy expands, and so are large government deficits.
• The risk: Data. Any disappointment would be met with heavy selling given the low conviction in valuations. Tariffs continue to be a wild card.

Howard Marks thinks it’s 1997 not 1999

Last week I mentioned famed investor Oaktree Capital Management co-founder Howard Marks due to his comments about the US stock market not having skipped a beat in 16 years and investors growing conditioned to the absence of corrections. But he also observed that we could be “in the early days” of a stock market bubble —  1997 than 1999. Contentious to be sure. But on its face, this means the rally has legs. Let’s outline why that might be the case. 

On Tuesday, the S&P 500 closed within three points of an all-time high despite growing focus on the Federal Reserve’s potential loss of independence. That’s even with the US index trading over 25 times earnings. 

Those earnings are doing very well though. Through Friday, S&P 500 companies had reported a 10.5% growth in earnings from a year earlier, according to Bloomberg Intelligence estimates. The Magnificent Seven megacap tech stocks that make up over a third of the index, have had even faster growth, adding a greater lift to the market-cap weighted index. 

The importance of the Mag 7 is underscored by Nvidia, where options imply a roughly 6% swing in the stock after it announces quarterly earnings after Wednesday’s market close. That’s approximately $270 billion in market value — or more than roughly 95% of S&P 500 companies. If Nvidia’s numbers are good, it will put a cap on what has been an unexpectedly robust earnings season.

Where does valuation enter into that picture? It doesn’t. Think back to late April when recession risk was near its highest. I mentioned that Walmart, a mammoth company with revenue growth around 5%, traded at a price of nearly 40 times earnings. My conclusion then still stands, that “If we avoid recession, the beat goes on — tempered by high valuations.” Companies like Walmart will do just fine as long as the economy does. The overall market can go higher behind the momentum in large cap tech.

Nvidia’s earnings release is representative of how bull markets work. Before the announcement, Bloomberg consensus estimates were for earnings of $1.01 per share, which translates into almost 50% growth over the same period a year ago. That’s absolutely huge for a company with quarterly revenue of nearly $50 billion.

There is little dispute in the options market about the company’s earnings growth. Most of the expected volatility is about how much they beat consensus and what they say about their revenue and earnings outlook. Amazon.com Inc., for example, beat expectations when it reported on Aug. 1. However, even though the AWS cloud computing unit beat forecasts, too, investors were disappointed that the outperformance wasn’t greater given stellar cloud computing results from Alphabet Inc. and Microsoft Corp. The stock fell. 

For Nvidia, current expectations — including whisper numbers — are in the share price. For the market to move higher, what matters isn’t how good the numbers are in absolute terms but how much they beat already lofty expectations. The wild card is their China revenue and any clarity or lack thereof could swing the market either way. 

While the bar is high, there is one sign the numbers won’t disappoint. The hyperscalers - the internet firms managing the physical infrastructure that enterprises use to host their digital platforms - like Microsoft and Alphabet are the ones driving Nvidia's chip sales. Those companies have already reported above-expectations numbers, even Amazon. This would be enough to keep the stock going — and pull the rest of the market with it. 

By the numbers

Long-term yields only matter at the margin

A lot of ink is spilled talking about interest rates. It mostly matters when policy is tight enough to make long-term interest rates prohibitively restrictive for the economy. Looking through the past year, financial conditions were extremely tight only after the April 2 tariff announcement. Markets have fully recovered from that episode to the point where one might even consider financial conditions loose.

Two factors play into that. One is that the market expects rate cuts going forward, with the swaps market and fed funds futures both priced for more than five quarter percentage-point reductions through the end of next year. Those rate cuts will keep financial conditions from tightening.

We also have a federal government adding a projected  5.6% of GDP in deficits to the private sector’s net financial asset position this year. That’s $1.7 billion of money US households and businesses are receiving in income that they can spend, sustaining the economy. For all the burdens that tariffs add by increasing the cost of imported goods, this stimulus might be just enough to steer the US economy away from recession.

By now, you’re probably asking how this is an Everything Risk newsletter if I’m painting a picture full of puppy dogs and rainbows. First, I am not fully convinced the big tech companies can keep spending so much on AI. When they cut back, watch out. More importantly, this is also where valuation comes into play. While you can’t time the market by looking at valuations, they certainly contribute to the magnitude of vulnerability in a downturn.

Since the US recovered from stagflation in 1982, the economy has spent most of the time in expansion. We’re in the fifth business cycle since 1982 and only 36 months of that has been in a recession. A whopping 527 months have seen the US economy expanding. Earnings go up during expansions and earnings multiples with them. But stocks tend to rise more than earnings during upturns in the economy until a recession threat emerges — and we’re not facing one yet.

The principal risk today then, given a high S&P 500 price-earnings ratio on both a trailing and cyclically-adjusted basis, is a downturn pulling stocks down as it did in 2000. The depth and length of that downturn matters too. If we can get over the coming months of inflation from tariff policy without one, then Marks is right that the AI-driven rally is still at an early stage — where dot com stocks were circa 1997 before collapsing in 2000. That would mean this rally has more to run.

Quote of the week

Things on my radar

• A steeper yield curve adds risk. Markets are not pricing those risks highly enough and when it comes to inflation watch for ‘ fiscal dominance’. 
• Governor Cook is the subject of the latest controversy around the Fed; one of Fed Chair Powell’s potential replacements, Kevin Hassett says she should resign now.
• Since we’re talking about bubbles, here’s a  sign of one: demand for convertible debt. In this case, we’re talking about convertible arbitrage where hedge funds take advantage of the discrepancy between convertible bonds and their underlying shares.
• Still, the popularity of ‘converts’ is reminiscent of the late 1990s when companies like Amazon took advantage of a rising market to issue convertible debt as a alternative way of issuing new shares.

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