The Big Picture
Briefing.com Summary:
*Valuations near 25-year extremes make it clear that investment risk is higher and return potential lower.
*The stock market could face some fourth quarter upset if current rate cut assumptions are challenged.
*Earnings estimates are the most important element for a stock market priced for perfection.
The stock market is at a record high. Hip hip hooray! Oh, and buyer beware!
This is a hot market that hasn't had a cooling-off period since the spring meltdown that followed the reciprocal tariff announcements. That is a good stretch of time that has featured 28 record highs for the market cap-weighted S&P 500, some good news, lots of better-than-feared news, and an unwavering sense of confidence in the economic and earnings growth outlook.
How do we know? Just look at the chart below.
That is a good-looking chart with an encouraging trend line. It is also only a snapshot in time. When you zoom out over a 25-year time horizon, the total return picture looks even better. It is so good, in fact, that valuations right now are scary.
A Keynesian View
Regular market watchers will have heard time and again that valuation is not a good market timing indicator. That is true. John Maynard Keynes observed that "the markets can remain irrational longer than you can remain solvent." That was a reminder to people betting against the market simply because they thought it was overvalued.
Valuation, however, always matters in the long run. Investors (note: we didn't say traders) need to be attentive to valuations when making investment decisions, because one's starting point matters for long-term return potential. Brace yourself, then; the following charts aren't as refreshing as the charts above.
The objective fact is that the stock market is trading at, or near, its richest point over the last 25 years, which has the dot-com boom and bust as one of its bookends.
This doesn't mean the stock market is going to fall off a cliff in the fourth quarter. It is possible that there could be further multiple expansion. What it means, though, are two things: 1) an investor's return potential investing in the index won't be as strong as it would be otherwise if starting from a lower valuation, and 2) the risk of a material loss investing in the index is higher in the event of a fundamental disappointment.
What would qualify as a fundamental disappointment?
- Inflation sticking at, or above, 3.0%, such that it prevents the Fed from cutting rates further or—gulp—necessitates a rate hike.
- Long-term Treasury yields climbing toward 5.0%, or exceeding 5.0%, at an accelerated pace because of concerns about a monetary and/or fiscal policy mistake.
- Rising unemployment in the face of sticky inflation that curtails consumer spending and gives way to a stagflation environment (i.e., low growth, high inflation, and high unemployment).
- A sales growth disappointment from NVIDIA (NVDA) that upends the AI growth trade; and/or sales and earnings disappointments across the mega-cap landscape.
- A spike in energy prices.
- A credit event that triggers tighter lending standards or destabilizes the financial system.
- An escalation of trade tension with China that leads to higher tariff rates and reduced trade activity.
- A geopolitical shock that upends global economic growth and earnings prospects.
Investing in the S&P 500 index has been a tried-and-true strategy for long-term investors. An investor should have a core position in that index, yet there are times (like now) when it is advisable not to put all your eggs in that one basket. A lower-risk approach to investing in the S&P 500 right now would be to buy an index call option, which allows for the possibility of capturing further upside but limits one's risk only to the premium paid for the option.
Other approaches to minimizing risk in a richly priced stock market include rebalancing, diversifying into alternative assets like real estate and commodities, adding exposure to high-quality bonds with less duration, allocating money to defensive-oriented sectors, investing in foreign markets, and raising some cash that can be deployed in the event of a larger market downturn.
The stock market today is priced for good outcomes in all respects. Participants know that, which is why it feels now as if the market is tip-toeing around the inconvenient truth that stocks, according to Fed Chair Powell, are "fairly highly priced."
Again, that doesn't mean that this bull market move is over. Former Fed Chairman Alan Greenspan questioned in December 1996 whether there was "irrational exuberance" in the stock market. The dot-com bubble didn't burst until March 2000.
Two Important Elements
There is no telling if this bull market has four weeks, four months, or four years left in it. It could be more, or it could be less. There are two important elements still working in its favor. The first is the resilience of the consumer, and the second is the earnings estimate trend.
When we say "consumer," we are talking in aggregate. Plenty of companies have called attention to the slowdown in spending among lower- and middle-income consumers due to higher price levels that have pinched their disposable personal income.
Debt service ratios and delinquency rates, however, have not exposed any undue systemic stress thus far; moreover, the wealth effect of rising stock prices and home prices has been an uplifting factor for consumer spending overall, which has nonetheless shown signs of moderating. The wealth effect and a labor market that has softened but is not decidedly weak are important factors when consumer spending accounts for nearly 70% of GDP. If they deteriorate, so will earnings prospects.
The second element is the most important element for a stock market that is priced for perfection. Embedded in the premium multiple is an expectation that earnings growth will remain at a premium. In that regard, the trend has been the stock market's friend. If the estimate trend breaks, the S&P 500 cradle will fall. How far it falls will depend on the degree of the break.
The stock market briefly came to terms with a more dour earnings outlook when the reciprocal tariffs were announced and triggered recession concerns. The chart shows, though, that those concerns were quickly smoothed over when those onerous tariffs were paused, and subsequently, as new trade deals got worked out, Congress passed the One Big Beautiful Bill Act, market rates dropped, and Fed rate cuts entered the narrative.
A staying factor for this bull market has been the recognition that the economy avoided a recession and that the Fed has started to cut rates (again) in a bid to shore up support for the labor market and to keep the economy on a growth trajectory. The fed funds futures market sees two more rate cuts before the end of the year.
With core-PCE inflation hovering near 3.0%, though, and many Fed officials expecting/fearing some pass-through of tariffs to pricing in the months ahead, our current house view is that two rate cuts before the end of the year is at least one too many, which is to say the stock market could be facing some upset as the fourth quarter progresses if that happens to be the case.
Briefing.com Analyst Insight
The stock market enters the fourth quarter with a premium valuation that is not solely the product of mega-cap valuations. In fact, every S&P 500 sector, except real estate, is trading at a premium to its 10-year average P/E multiple.
High valuation(s) are our chief concern for investors. Therefore, if putting new money to work for longer-term investing, we would lean into those areas with less demanding valuations relative to historical averages. That would be real estate, health care, and utilities. They also happen to have a more defensive orientation, which could afford them relative strength in the event of a market correction.
Still, one can't forego exposure to the growthier parts of the market. They will remain a crowd favorite so long as the growth outlook is undisturbed. They have outperformed the market this year, and knowing that, we are reminded of Newton's First Law of Motion that an object in motion tends to stay in motion unless acted upon by an unbalanced force.
Market participants have not been unnerved by any unbalanced forces to this point. There is an expectation that many high-flying stocks/sectors are due for a pullback, but alongside those expectations are clarion calls that pullbacks should be viewed as a buying opportunity. Such is the mantra of a bull market, and we are indeed in a bull market.
We have the scary-looking valuations to show for it.
