Stocks are climbing, scaling new heights while euphoria abounds. Momentum is pushing the technology sector, and AI stocks in particular. How long can it last and how high can it go?

 

It is the question on the minds of many on Wall Street. At this point, the consensus opinion is that we are due for a pullback. Even the bulls are getting worried as valuations become stretched.

 

However, valuations are in the eye of the beholder. While the price-earnings ratio of the market is about 21 percent, if you remove a handful of mega-cap stocks the average is only 17 times earnings. That handful of stocks has accounted for more than 50 percent of the gains this year in the S&P 500 Index. The Magnificent 7 (Meta, Apple, Amazon, Alphabet, Microsoft, Nvidia, and Tesla) have long held leadership positions within the equity market. Recently, however, a few additional stocks have joined this pack of champions.

 

The "AI 5" (Nvidia, Microsoft, Advanced Micro Devices, Taiwan Semi-Conductor Manufacturing, and Broadcom) are companies that Wall Street analysts believe are leaders in the development of artificial intelligence. All but one (Microsoft) are semiconductor stocks. Momentum in these stocks as well as most of the Mag 7 stocks is through the roof. The last time we saw momentum at this level was in November 2021.

 

Market momentum, for those who are not aware, is the capacity for a price trend in a stock, stocks, or markets to continue and sustain itself (either higher or lower). As the AI movement picked up steam this year, for example, prices rose, traders jumped on the bandwagon, volume increased, prices climbed even higher, and more and more buyers piled into this group of stocks. A herding mentality has taken over and the chase is on!

 

There are plenty of money managers and traders who make a living buying and selling momentum. The idea is to buy the asset when it is rising and then sell after it has peaked in price. Don't be fooled; this is a dicey business. It is a trading maneuver that relies on a greater fool theory and has nothing to do with the fundamental value of the underlying security. 

 

In today's market, many investors are marveling at how high prices Microsoft Nvidia or any of the other Mag 7 and AI 5 stocks have reached. The same momentum trend helps explain why the stock markets, and particularly the technology sector, are pushing higher and higher. There is nothing new in this behavior. It has happened many times in the history of the stock market.

 

What happens next? At some point, the trend of chasing these stocks peters out. Momentum traders will usually be alerted by technical and computer programs that it is time to reverse positions. The highflyers will be sold and/or shorted. Those unfortunates that purchased at the peak will be left holding the bag.

 

Unfortunately, given that the market capitalization of these stocks is in the vicinity of several trillion dollars, the impact on the overall market will be quite large. It is one of the reasons that I believe the coming pullback in stocks could be between 7-10 percent. That may sound like a lot, but it would only be a normal correction in the history of the S&P 500 Index.

 

But before you rush out to sell everything, let me caution that no one knows how far the momentum game can carry stocks. This week we hit 5,000 and beyond on the S&P 500. That is a nice round number but has little significance otherwise. Given the right circumstances, we could see 5,150 or even higher in the weeks ahead. What I wouldn't do is add more money to the Mag 7 or AI 5.

 

Bill Schmick is the founding partner of Onota Partners, Inc., in the Berkshires. His forecasts and opinions are purely his own and do not necessarily represent the views of Onota Partners Inc. (OPI). None of his commentary is or should be considered investment advice. Direct your inquiries to Bill at 1-413-347-2401 or email him at bill@schmicksretiredinvestor.com.