Investors Express Concerns over Elevated Valuations of US Stocks
Some Wall Street banks are expressing caution regarding the recent rally in US stocks, citing stretched valuations that have increased the vulnerability of equities to potential declines. While the S&P 500 has experienced a pullback for the week, it has still gained more than 13% since the beginning of the year, driven by factors such as moderating inflation, advancements in artificial intelligence, and a growing risk appetite.
However, these gains have led to higher valuation levels. The S&P 500 currently trades at 19 times its expected 12-month earnings, well above its historical average of 15.6 times. Past instances of similar valuation levels have often been followed by periods of volatile performance. Goldman Sachs notes that the S&P 500 has historically seen a median drawdown of 14% over the next 12 months when valuations are at or above current levels, compared to the typical 5% drawdown over a year.
Investors are concerned about potential catalysts that could cloud the market outlook, such as unexpected economic weakness, a more hawkish stance from the Federal Reserve, and a resurgence of inflation. Wells Fargo Investment Institute (WFII) recently downgraded the technology sector, which has been leading this year’s S&P 500 rally, citing unattractive valuations. Goldman Sachs advised investors to consider implementing downside protection measures in their stock portfolios, despite expecting the S&P 500 to reach 4,500 by year-end.
Valuations are even more stretched in the Nasdaq 100, which has rallied 36% this year, surpassing the gains of the S&P 500. The index now trades at nearly 27 times forward earnings estimates, compared to its historical average of 19.3 times. Market observers point out that the earnings outlook for high-growth companies in the Nasdaq 100 is less robust compared to 2021, making it harder to justify the lofty valuations.
Technical indicators are also raising concerns among investors. Michael Purves, CEO at Tallbacken Capital Advisors, noted signs of weakness in indicators related to trends and momentum, suggesting that the momentum-driven trade may be losing steam.
As the second quarter comes to an end, investors will closely monitor upcoming economic data, including key inflation figures, to gauge the health of the economy. While there are reasons for caution, such as investor positioning reaching its highest level since January 2022, some market participants believe the rally could continue. The S&P 500’s significant move above its October lows has led some to view it as entering a “bull market” phase, and historical trends indicate that stocks tend to keep rallying after surpassing the 20% threshold.
The optimism surrounding the market is further fueled by the outperformance of sectors like industrials and materials, indicating a potentially broader rally beyond the tech and mega-cap stocks that have primarily driven this year’s gains. However, analysts suggest that a cooling-off period or a pullback may be on the horizon due to the index’s rapid surge above its short and long-term technical trend lines.