Elevated stock prices reflect confidence that U.S. economic growth and consumer spending will continue to improve. That may not happen.

It can be easy to confuse strong stock market performance with a vibrant economy and robust corporate profits. In the case of this year’s 26% climb in the S&P 500, those high returns seem particularly deceiving. 

This year’s gains have been driven mainly by Fed rate cuts and expectations for improvement in trade tensions, not strong economic growth. In fact, U.S. GDP growth is slowing, manufacturing is in recession and corporate profits are in decline. U.S. stocks now look very expensive relative to earnings. The price/earnings multiple of the S&P 500, a key measure of valuation, is now 18.7, up from 14.5 a year ago. In the last 40 years, it has only been that high about 25% of the time.

I think investors may be overly optimistic that a number of economic measures will keep improving. Below are three areas where there seems to be a growing wedge between reality and investor expectations:

  • Economic indicators are worsening in the U.S. While global numbers have improved, U.S. based measures of industrial production, capital spending, inventories and retails sales have not only been down recently, but by more than economists forecast. Surveys by regional Federal Reserve banks show business confidence is flagging.

  • The U.S. consumer may not be as strong as expected. Consumer confidence may be peaking while credit card spending is shrinking—a sign that consumers are tapped out, despite low interest rates. Uncertainty around the Presidential election could hurt confidence going forward. Can consumer spending really remain immune to declining corporate confidence and profits? I am doubtful.

  • The labor market could weaken. The biggest threat to consumer spending is typically a weaker labor market. That could happen if companies respond to slower revenue growth and shrinking profits by cutting jobs. Weekly initial jobless claims have started to inch up. Hiring may have peaked.

With the odds of disappointment rising while stock valuations are high, I think U.S. markets are vulnerable. Under these circumstances, I recommend investors diversify into sectors and regions that aren’t so expensive.

As year-end approaches, consider taking profits in U.S. winners and rotating into non-U.S. markets, financials, commodities and actively-managed funds that use strategies that may have positive returns, even if the S&P 500 does not.