Will the US stock market see a return of the risks from the 1930s?

Since the Federal Reserve began an aggressive rate-hiking cycle, the U.S. stock market has repeatedly hit new highs amidst a chorus of pessimism, defying market expectations. What does this indicate?

Recently, Wall Street veteran and renowned columnist Richard Bernstein wrote that despite the significant increase in benchmark interest rates by the Federal Reserve since the beginning of 2022, the outstanding returns of highly speculative investment strategies demonstrate that this most aggressive rate hike in nearly 30 years has not fully absorbed the excess liquidity in the financial markets.

In other words, the financial markets are already filled with bubbles.

According to Bernstein, bubbles can lead to capital misallocation, flowing into unnecessary assets (such as cryptocurrencies and meme stocks) rather than truly driving productivity, which will become the root cause of future actual asset inflation. In fact, since the dot-com bubble in 2000, the U.S. PCE price index has already reached a peak of 5.6%.

Behind the strength of large-cap stocks, a storm is brewing

Bernstein added that the misallocation of capital is also manifested in a "peculiar" phenomenon in the current market: despite the narrowing of credit spreads, large-cap stocks continue to outperform small-cap stocks under the boost of the "Big Tech Seven Sisters."

However, historically, due to the small size and high leverage of small-cap stocks, they are more sensitive to economic and profit cycles. Therefore, when overall corporate profits improve, small-cap stocks often outperform large-cap stocks, and credit spreads narrow. Conversely, the performance of large-cap stocks tends to be better than that of small-cap stocks, and credit spreads widen.

Clearly, speculative behavior in a high-interest rate environment over the past two years has significantly distorted this long-standing market relationship.

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

The "triple facts" brought by capital misallocation

The article suggests that this extreme differentiation may indicate or foreshadow three situations:

First, the extent of improvement in corporate profit environment is underestimated.

The article states that behind the exceptional performance of the "Big Tech Seven Sisters," the market may have overlooked the fact that corporate cash flows are widely improving, including the tightening of credit spreads. Data shows that around 160 companies in the S&P 500 index have achieved profit growth of over 25%.

Second, although the current stock market rally is highly concentrated, it is unlikely to trigger another Great Depression.

Goldman Sachs had previously issued a warning, suggesting that the current high concentration of gains in the U.S. stock market seems to be replaying the collapse crisis of the 1930s. However, Bernstein believes that considering the accelerating corporate profits and the healthy performance of the banking system, this possibility seems unlikely.

Lastly, cyclical stocks are expected to rise.

The article points out that excess liquidity may be driving speculative behavior in the stock and fixed income markets. If this situation is true, then those non-defensive sectors (such as emerging markets and small-cap stocks) may become investors' "safe havens" in the current stock market turbulence Historical data shows that after the bursting of the technology bubble in 2000, although the overall U.S. stock market experienced a "lost decade," energy stocks, commodities, emerging markets, and small-cap stocks performed well.

The article explains that these sectors mainly benefited from capital exiting the technology stocks and profit growth driven by inflation following the bursting of the bubble