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A risky trading strategy is playing out in a Big Tech-dominated stocks rally

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The mega-cap, FOMO-driven stock-market rally suggests that investors are playing the “greater fool” games on growth stocks, and their overextended valuations could mean a weak decade ahead relative to value stocks, according to Stifel’s chief equity strategist Barry Bannister. 

Bannister and his team drew parallels between the current AI-driven U.S. stock rally and the dot-com bubble that ballooned in late-1990. The chart below shows that growth stocks tend to outperform value stocks when the market breadth weakens, and it could prompt a red flag for the stock market, just like the 1999 dot-com bubble.

“Growth loves ‘Goldilocks,’ but ‘bad breadth’ has limits as we found in the tech bubble 25 years ago,” they said in a Tuesday client note (see chart below).

SOURCE: BLOOMBERG DATA, RUSSELL 1000 INDEX VALUE AND GROWTH INDICES

See: Today’s Big Tech-dominated stock market has shades of dot-com bubble, strategists warn

Meanwhile, while megacap technology stocks do generate “impressive earnings growth,” the price investors pay may reflect “too high hopes” in the market, said Bannister and his team.

For example, the price-to-earnings ratio for growth stocks is now bid up to a “magnificent” level compared with value stocks, and that divergence could mean large-cap growth stocks are heading to a “weak decade” with lower 10-year forward annualized returns relative to their value counterparts, the strategists said.

Read more: The stock market’s ‘bad breadth’ is making even stalwart bulls nervous

That also means that growth versus value stocks is now in a “greater fool” stage, Bannister and his team said. The greater fool theory of economics suggests that there will always be someone in the market who is willing to pay a higher price for an already overvalued asset, and this person will be left stuck when the bubble bursts, as the majority of investors finally realize the valuation of the underlying security is not justified.

The greater fool theory is a risky and speculative strategy and usually applies to bubble markets like housing, but recently it has been used to characterize cryptocurrencies. 

The relentless rally in the S&P 500 over the past year has also created a situation in which the value proposition is not growth but value stocks, Bannister and his team said, adding that a potential soft-landing scenario for the U.S. economy could provide a timely entry point for cyclical value stocks.

A persistent economic growth and sticky inflation above the Fed’s 2% core PCE target could benefit stocks in the financials, industrials, materials, real estate and energy sectors, which are known for following the cycles of an economy and tend to produce higher returns during periods of economic strength, Bannister and his team said.

U.S. stocks were mostly lower on Tuesday with the Dow Jones Industrial Average
DJIA
edging up 0.1%, to 38,414, while the S&P 500
SPX
was dropping 0.1% and the Nasdaq Composite
COMP
was falling 0.4%, according to FactSet data.



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