Top-Heavy Market Could Finally Turn
Even after the recent pull back, many parts of the market are not reflecting reality. Let me show you what I mean with this HVAC-focused stock.
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A better-than-expected December jobs report on Friday pushed the yield on the 10-Year Treasury up further. Ten-year Treasuries ended the week just over the 4.75% threshold. The major indexes all fell just over 1.5% on Friday. The Dow and S&P 500 lost 1.9% for the week. The Nasdaq was off 2.3%, while the small cap Russell 2000 pulled back approximately 3.5%. The Dow now has given up all of its post-election gains.
I have been quite adamant, as has the Daily Diary, in recent quarters, that the market has gotten historically top-heavy. Most of the earnings growth and most of the market gains over the past two years have come from a very few mega-cap stocks. I have also been warning for several months now that investors were being entirely too nonchalant about the rise in debt yields. These have been moving in the opposite direction of the fall in the Federal Funds rate since Chairman Powell started reducing this key interest rate at the mid-September Federal Open Market Committee meeting.
The last major concern I have around the overall market is around valuation. By some metrics like price to sales or market cap to U.S. GDP ratio, equities are more dearly valued than at the end of the internet boom. It is not only the stocks that have driven bull market since the end of 2022 like Apple AAPL that look frothy. It is some of the more mundane names that feel more than overbought, too.
Take Trane Technologies TT. This industrial company was known as Ingersoll Rand until it took its current name in 2020. The stock has nearly tripled over the past two and a half years. Management has done a commendable job churning out earnings gains in the low teens. That said, the stock trades near 35-times earnings, a roughly 40% premium to the S&P 500. The equity pays an under 1% dividend yield as well. Those would be stretched valuations back in the days when the Federal Reserve was maintaining a zero-interest rate -- ZIRP -- stance. It now seems somewhat farcical when 10-Year Treasuries are moving toward 5%. This is basically an HVAC-focused company, after all. One that might be impacted by new trade and tariff policies of the incoming administration to boot.
I am not picking on Trane, I have the same lament about the valuations of other companies in similar industries. As investors start to better factor a "higher for longer" environment for interest rates, these types of equities could face significant downward pressure. This change in sentiment has already washed over the home builders, building supply companies and names like The Sherwin-Williams Company SHW, which I have highlighted in recent months as being priced for a reality that was very unlikely to happen.
I think the recent weakness we have seen in equities in recent weeks has further to run. Stocks could have farther to fall as the market goes through a long overdue valuation inflection point.
At the time of publication, Jensen had no position in any security mentioned.
