ROI-Five charts sounding the alarm for stretched US markets: McGeever

US stocks and bonds currently appear highly stretched on several key measures, suggesting investors should tread with extreme ​caution. The big question is whether we may be at, or near, an inflection point.

Wall ​Street's record-breaking highs mask historic levels of concentration and narrow breadth. ‌Treasury ​yields are now so high that, depending on your perspective, they either represent a generational buying opportunity or are about to send the equity rally screeching into reverse. Meanwhile, the spiking “term premium” could slam both stocks and bonds. But does that indicate mean reversion is just around the corner? It’s tough to say.

Historically ‌high AI-related profits and healthy economic growth could maintain Wall Street's bull run for months if not years, and there's no shortage of reasons why yields cannot rise further, and not all of them are negative. Below are five charts that bring this debate into focus:

Tech and AI stocks now comprise over 40% of the S&P 500's market cap. That's higher than the peak of the dotcom bubble in early ‌2000. Add in AI-related companies, and tech's footprint tops 50%, also a record. This level of concentration is fine when tech is surging, but concerns are mounting about the AI revolution, including safety issues ‌and doubts over the technology's long-term economic viability. A turn in AI sentiment could spark a serious correction. On the other hand, if the hundreds of billions of dollars in AI investment start to pay off, the rally could get supercharged. The current ratio of the equal-weighted S&P 500 index to the market cap-weighted index is collapsing, based on Invesco's RSP EW exchange-traded fund and the SPY ETF. In plain English, the main US index in which stocks have equal weighting is under-performing the more ⁠widely followed index ​by the widest margin in 24 years. That’s almost ⁠entirely due to the strong performance of tech and AI names, suggesting corporate America overall is not quite as strong as the record-breaking S&P 500 headlines suggest.

Investors usually demand a higher rate of return when buying “riskier” stocks versus traditionally “safe” bonds. ⁠This difference between the earnings yield on stocks and the 10-year Treasury yield is referred to as the “equity risk premium”. It is currently the lowest in 24 years and is actually negative – a very rare occurrence this century. This should ​be a signal for investors to start rethinking the size of their equity allocation, though, as of now, we certainly aren’t seeing many signs of that. The yield on 30-year Treasury ⁠Inflation-Protected Securities (TIPS) is nearing 3.40%, the highest since 2002. That represents the near-guaranteed inflation-adjusted – or “real” – annual rate of return investors can now lock in for the next 30 years. Again, one might expect that to pull capital away from equities and help prop up the ⁠ailing ​bond market, especially as rising real yields are usually indicative of stronger economic growth. Spiking yields should also negatively impact corporate borrowers at some point – the question is when that might be.

Last but not least, the “term premium” – the market’s wild card. This is the estimated level of extra compensation investors demand in return for buying long-dated Treasuries over short-term debt. What’s pushing up the term premium remains an open ⁠question – it could be growing doubts around Fed credibility, US debt debasement fears, or something else entirely. But no matter the cause, the main concern with the term premium is always whether it’s rising ⁠or not. If it is, it's potentially a signal of ⁠more fundamental problems that could have serious economic and market consequences. And right now it's rising sharply. (The opinions expressed here are those of the author, a columnist for Reuters)

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(By Jamie McGeever. Editing by Marguerita Choy)