Warm weather, longer days and summer vacation plans tend to make everyone a little more optimistic – including investors. That may be why the Standard & Poor’s 500 is showing signs of breaking out of the narrow trading range (3,800 to 4,200) that has defined it for the last six months.
In fact, several of the major indices, including the Nasdaq 100, are priced for a boost—but investors should be cautious. Market fundamentals are less attractive today than they were six months ago, and we think risks are elevated and even increasing in several instances.
This sudden sunny disposition has corresponded with a change in market leadership. Late last year, the leaders were energy, materials, financials and industrials, while technology was the big laggard. Small caps were also doing much better than the broader market, with prices rising across a wide swath of stocks, thanks to a bullish narrative around China’s reopening and its implications for global growth.
It’s a very different dynamic today. As my colleague Lisa Shalett also noted this week, market breadth is very narrow, meaning that just two sectors, technology and consumer, are up this year, and the market’s strength is coming from a small group of stocks. Investors are more bullish than in early December, or at least far less bearish, thanks largely to optimism around broader use of technology, and specifically artificial intelligence. While AI could lead to some substantial efficiencies that help fight inflation, it’s likely no match for the earnings recession that we forecast for this year. What’s more, the recent rally has sparked buying by investors who are afraid they’ll miss the next bull market.
We believe this rally will prove to be a “head fake” like we saw last summer, for a number of reasons:
Stock valuations are not attractive. It’s not just the top 10 to 20 stocks that are expensive. The S&P 500 median stock forward P/E is 18.3x (in the top 15% of historical levels back to the mid-1990s). Even if we exclude tech stocks, the median P/E is 18.0x (also within the top 15% of historical levels) and the equity risk premium—or how much a stock is expected to outperform a risk-free investment over time—is only 2%.
Earnings estimates appear too optimistic. Consensus earnings estimates are assuming a very healthy re-acceleration for the second half of the year—with markets forecasting mid-to-high single-digit growth for the index overall, even with technology removed. This flies directly in the face of our forecasts, which continue to point materially lower. We remain highly confident in our model, which is now forecasting a much poorer outcome than the consensus. In fact, we think earnings estimates are off by as much as 20% for this year.
Investors seem unrealistic about rate cuts. The equity market is now pricing in Fed cuts before year-end without any material implications for growth. Yet, Morgan Stanley economists believe the Fed will only cut rates if we definitively enter a recession, or if stresses in the banking system increase or credit markets deteriorate significantly. What’s more, assumptions for Fed cuts implicitly assume that inflation will fall to at least 3%. That is possible, but not without significant growth implications.
Markets may be overlooking other key risks. There’s also a presumption that the banking situation will not worsen, consumer spending will stay strong and risk related to the debt ceiling has resolved. While we don’t think the current banking environment is a repeat of 2008 and 2009, we do think banking stresses will accelerate the credit crunch that was already likely to begin by year-end, based on loan officer surveys from January. And while consumer spending has been quite resilient, some signs are emerging that this strength may finally be fading.
Finally, although a debt-ceiling resolution removes a near-term market risk, the potentially bigger risk for markets now is that raising the debt ceiling could decrease market liquidity as the government issues a significant number of Treasury bonds. In fact, passing the debt ceiling may—ironically—be the catalyst that ends this bear market rally, as it leads to a contraction in liquidity.
Bottom line: The major indices are priced for increases based on multiple assumptions in areas where we think risks are elevated and even increasing. Beware of a false breakout as markets peak on good news.