Expert Who Called Dot-Com Bubble Warns Stocks Detached From Reality

In a March 28 client note, Edwards poked holes in the notions that AI will positively impact earnings in the near future and that an economic recovery is really occurring. The crux of his argument lies in the falling optimism of Wall Street analysts.

While analyst optimism about earnings surged after the release of ChatGPT 3.5 in late 2022, it has since cooled, with a downtrend emerging on a 6-month moving-average basis. About 45% of changes to S&P 500 analysts’ earnings estimates are upgrades, as shown in the chart below, down from 50% in early 2023. A downtrend in analyst sentiment is also present for the Nasdaq 100, Edwards said.

Historically, analyst optimism has been a good indicator for the economy’s direction. Here’s the 6-month moving average of the percentage of S&P 500 positive earning-estimate changes paired with The Conference Board’s Leading Economic Index, which has recently started trending upward though it remains in what has historically been recession territory.

And here’s the same earnings upgrade percentage along with the Institute for Supply Management’s US manufacturing index, which is also rising.

Analyst optimism also tends to be tied to stock-market performance. Below is the S&P 500’s year-over-year percentage change along with the analyst optimism measure.

So, who should you believe? The indicators that are on the upswing, or the analysts? For Edwards, it’s the latter.

“A clear change in direction in analyst optimism is usually a good cyclical ‘straw in the wind’ of a change in fortune for an economy. On that basis the closely watched manufacturing ISM index, which typically moves in step with analyst optimism, is now at risk of a surprise downturn,” Edwards said. “All I can say is that for analyst optimism on the S&P to have topped out only at 50% before subsiding is not the stuff of normal cyclical recoveries, let alone an AI ‘new era.'”

As for the stock market, Edwards thinks liquidity being pumped into the economy by the Fed via the repo market and relatively dovish central bank messaging as of late may be more responsible for the recent rally than investor optimism. He believes the market is now in a bubble, with fundamentals disconnected from reality.

“Just as Powell’s first surprise pivot in December 2018 was the launchpad to propel tech stock valuations skywards, this second pivot has sent tech valuations into the stratosphere,” Edwards said. “Valuations are getting so frothy that even a long‑time bull like Ed Yardeni is worried that the Fed is creating another 2000-like bubble.”

He added: “Is this anemic profits backdrop really consistent with the S&P rising by one third in a year? Maybe it’s all about Fed-induced liquidity after all?!”

Edwards’ views in context

While the relationship between analyst optimism and the performance of the stock market and economy have been historically close, as Edwards highlights, it may turn out that analysts are simply too bearish. Let’s not forget that market consensus was famously wrong about the 2022-2023 recession that never came.

March jobs data released by the Bureau of Labor Statistics on Friday put another dent into Edwards’ argument against an ongoing economic recovery. The US added 303,000 jobs last month, the Bureau said, smashing economists’ expectations for 212,000. The unemployment rate also ticked back down to 3.8% from 3.9%.

There’s also the possibility that the current cycle is different, which Edwards allows for, and normal economic measures aren’t as reliable this time.

“The reasons why the economy has withstood the Fed’s rate hikes are well understood – especially in retrospect. These include huge fiscal stimulus, consumers tapping into ‘excess’ pandemic-era savings, large companies actually benefiting from higher interest rates and ‘Greedflation’ boosting profit margins,” he said. “Typically, monetary tightening only truly ‘bites’ with long and variable lags but seems to be taking even longer than ‘usual’ this time around.”

But recession risks are still present, and perhaps paradoxically, the stronger the economy performs today, the greater the risk of a potential downturn in the future. This is because hot economic data may lead the Fed to keep rates higher for longer, putting a strain on the economy over a longer period of time.

Bears are increasingly rare in this market, but they do still exist. One notable naysayer is Jeremy Grantham, the cofounder of GMO called the 2000 and 2008 crashes. He says the S&P 500 is in a bubble fueled by AI optimism and could fall as much as around 60%. Another is David Rosenberg, founder of Rosenberg Research and former Merrill Lynch chief economist who called the 2008 crash. He sees potential downside of 39% for the S&P 500.

Investors will have to wait and see how economic data and earnings reports fare in the months ahead, and how the Fed approaches policymaking. Those factors will likely dictate whether bulls can continue to ride the rally or whether skeptics like Edwards are proven right.