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HomeMarketThe Stock Market Is on a Tear. It’s Almost Time to Sell...

The Stock Market Is on a Tear. It’s Almost Time to Sell the Rally.

A scene from the trading floor of the New York Stock Exchange.

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Spencer Platt/Getty Images

The stock market has seen a major rally recently. Another move lower looks likely. 

The S&P 500 is up about 13% from its lowest close of the year, 3577, hit in early October. The main driver is that the rate of inflation is declining, evidence of which has emerged in multiple pieces of economic data. This means the Federal Reserve can soon slow down the pace of interest-rate increases, which are meant to cool inflation by reducing demand for goods and services. Rising interest rates are trouble for stocks because a slower-growing economy can hurt corporate profits.

While the market flatlines for a while when some rallies peter out, the current one could end abruptly, with a decline.

For starters, the
S&P 500
is nearing a so-called resistance level right now. At just over 4000, the index isn’t far below the 4200 to 4300 area where sellers came in earlier this year, knocking the index lower. The market could easily rally toward that level, but if it does, sellers are still likely to step in aggressively. 

A rise toward 4200 or 4300 likely would make the market unsustainably expensive. At 4300, for example, the S&P 500 would be selling at about 18.5 times the aggregate per-share earnings its component companies are expected to bring in over the coming year. The low this year was around 15 times.

With the S&P 500 at 18.5 times forward earnings, the annual profits of companies in the index would amount to about 5.4% of their aggregate price. That is only 1.6 percentage points higher than the yield on 10-year Treasury debt. That extra return—the so-called equity risk premium—has averaged closer to 4% since the end of the 2008-2009 financial crisis, according to
Morgan Stanley.

The index’s valuation, or multiple, isn’t usually a trigger for declines, but the higher it goes, the more vulnerable the market is to a drop.

This time, fading optimism about corporate profits could help set off a decline. Analysts’ estimates of aggregate 2023 per-share earnings for S&P 500 companies have declined by a few percent in the past several months, according to FactSet. But because higher interest rates usually damage economic demand with a delay—the Fed only began its latest series of increases in March—analysts may need to lower their profit forecasts still more.

That is especially true because next year’s EPS forecasts haven’t fallen as much as they historically do in the final months of the year. And if EPS projections fall and stock prices don’t, multiples rise, making stocks even more expensive. That would make stocks too pricey for anyone but buyers who plan to hold shares for years, if not decades.

“To sustain a gain much above that [4200], one must either expect that valuations expand to well above normal levels or that earnings surprise to the upside,” wrote Keith Lerner, co-chief investment officer at
Truist.
“While plausible, we don’t see this as a favorable risk/reward proposition.”

Signals from Fed officials that while they are getting closer to slowing down in raising interest rates, it will be a while before they stop lifting borrowing costs, could throw the market for a loop as well. With the rate of inflation still well above the Fed’s 2% target, Fed speakers are likely to make comments suggesting no pause in tightening is coming soon.

“Investors should be cautious,” wrote Lauren Goodwin, economist and portfolio strategist at New York Life Investments. “October’s inflation report was not a game changer for the Fed; it was only a hopeful first step in that direction.”

None of this means the market will necessarily make a new low. It just means it might have to experience another selloff before resuming its climb. 

Write to Jacob Sonenshine at jacob.sonenshine@barrons.com

Credit: marketwatch.com

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