Another day, another record high for US stock markets. A prudent investor might be torn between wondering when the market becomes too expensive to participate in and remembering the old maxim that “the trend is your friend”. Another maxim I heard when I first started in stockbroking back in 1986 was “Trees don’t grow to the sky”. That was just in time for the Crash of ’87.
Some are suggesting that we are entering a “melt-up” market, where prices continue to rise as index funds are forced to buy, and latecomers feel the need to join the party. How does one know when the market is becoming irrational? It’s a very tough question, and markets often travel a lot further (up or down) than expected – markets tend to overshoot in either direction.
The US market is up 38% over the last 12 months
Source: Trading Economics
Can one define a “melt-up”? Ed Yardeni suggests that the S&P 500 is melting up whenever the S&P 500 forward price to earnings (P/E) is rising much faster than S&P 500 forward earnings per share (EPS), suggesting mounting “irrational exuberance.” In 1996, Former US Federal Reserve (Fed) Chair Alan Greenspan famously asked, “But how do we know when irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged contractions…” In a stock market bubble, investors must have very high expectations for earnings growth and very low-risk assessments to justify the market’s lofty valuation levels. These assumptions might be irrational thus setting up the melt-up for a meltdown, or at least a severe correction.
Are we there yet? It’s hard to say, but we may be getting closer to that scenario. The stock market continues to ignore geopolitical risks, especially in Eastern Europe and the Middle East, and also domestic political risks as the US elections approach. Ukraine is struggling against Russian advances, and we still await Israel’s widely expected retaliatory response to Iran’s missile attack several weeks ago. In the US, a very close presidential election could be unsettling if it is bitterly contested. On the other hand, a sweep by either party could lead to legislative successes for extremist policies with inflationary and deficit-bloating consequences. In our view, Trump seems to be on the ascendancy, with markets relaxed about that outcome.
Since the start of the latest bull market on October 12, 2022, the forward P/E of the S&P 500 has increased 43% from 15.3x to 21.9x. Over that same period, forward earnings per share increased 14%.
Source: Yardeni Research
The forward P/E of the US market is fast approaching its previous two cyclical peaks (22.6x in January 2021 and 25.5x in July 1999). This is mostly attributable to the fact that the forward P/E of the S&P 500 Information Technology sector – which includes the Magnificent 7 stocks – is relatively high at 28.9x, though well below the 55x reading during March 2000 (the height of the dot.com boom).
Source: Yardeni Research
The S&P 500 Information Technology sector currently accounts for 32% of the market capitalisation of the S&P 500, similar to the peak share during the Tech bubble of 1999/2000. What is different this time is that the sector’s earnings account for 24% of the S&P 500’s earnings compared to less than 18% during the Tech bubble. Moreover, current earnings are more sustainable and high quality than during the late 1990s.
Our view is that the US economy should continue to grow at a robust pace, thus boosting earnings for the overall S&P 500. Certainly, valuation metrics are challenging and at extreme levels, but if earnings growth is delivered and rates continue to fall, markets can consolidate at these levels. Downside risks are mostly attributable to adverse geopolitical and domestic political developments through the end of this year. But as prudent investors know, there are often nasty surprises that come out of nowhere. It doesn’t hurt to occasionally take some profits off the table.
