Why Wall Street Is Overbought

By David Bassanese | More Articles by David Bassanese

After a nice further leg up in prices since late January, Wall Street now looks over extended and a decent price correction of at least 5 to 10% could now be underway and possibly play out over the next month or so.

As such it would seems an inopportune time to be placing a lot of new money into the market.

That said, the longer-term outlook for the market remains encouraging, provided the US economy keeps motoring along and interest rates don’t rise too far too fast.

Indeed, given there seems so many investors waiting on the sidelines to “buy the dip” there’s even a risk a decent correction never arises and, instead, we merely get an extended period of frustrating sideways price action.

So why the caution? For starters, the market again appears overbought. Indeed, the market has just enjoyed its third leg higher in prices since the election of Donald Trump to the US Presidency last November.

As seen in the chart below, the S&P 500 Index initially surged through much of November, then endured only a minor 1% pullback over a one week period. Prices then lurched higher in early December only to then enter a sideways trading range following the Fed’s decision to raise interest rates. By late January, however, prices took-off again, reaching “oversold” levels by late February – according to the technical relative strength indicator (RSI) – before a pull-back set in so far this month. As it stands, however, the market pull back so far is still only a little over 1%.

But another increasingly tough headwind for the market is that prices have risen faster than underlying earnings of late, meaning valuations have become even more stretched. Using Bloomberg consensus earnings data, the S&P 500’s price to forward earnings ratio reached a high of 18 at end-February, at the very top end of its range over the past decade or so. Of course, relative to still historically low bond yields, valuations are some less stretched – but stretched nonetheless. And even then, let’s not forget bond yields are also facing upward pressure.

While US 10-year bond yields have been trapped in a 2.3 to 2.6% trading range since the Fed raised rates last year, they have lifted in recent days (with the Fed sounding hawkish) are now close to breaking out to the upside. Only a few weeks ago, few traders thought the Fed would be game enough to raises rates as early as the March policy meeting. But a few choice words by a gaggle of Fed speakers, including Janet Yellen, saw the market swing to price with virtual certainty a rate hike on March 15.

Given the underlying strength in the US economy – and particularly the very tight US labour market – there seems little reason for the Fed to dally, and may see merit in front loading more rate hikes while market’s are still buoyed by optimism surrounding the Trump Presidency. That suggests another move in June (but not May) could be on the cards.

All up, a move higher in bond yields should place downward pressure on the stock market’s pricey level of valuations. With 10-year bond yields at 2.6%, my long-run valuation model suggests fair-value for the S&P 500’s forward PE ratio is 16.5. Should yields reach 3%, the fair-value PE ratio drops to 16.1, or a full 10% below end-February levels.

Of course, there’s then the question of earnings. The good news is that US forward earnings are rising. Even allowing for the usually overly optimistic outlook by analysts, my estimates suggest forward earnings could rise by around 6% between end-February and end-December. If we get the usual level of analyst earnings downgrades and rising bond yields push down PE valuations, the S&P 500 could end this year pretty close to where it began.

To be more positive, we’ll need to see a smaller than usual downgrade to analyst earnings expectations through the year – which, of course, is possible if economy continues to improve and especially if Trump follows through with promises tax cuts. Such optimism could also see stocks continue to trade on the pricey side of fair-value (relative to bond yields). Last but not least, also encouraging is the fact that I doubt bond yields or inflation are likely to break out in a major way – at most I expected to see US 10-year bond yields end the year around 3%.

About David Bassanese

David Bassanese is one of Australia's leading economic and financial market analysts. His is Chief Economist with BetaShares and former market columnist with The Australian Financial Review. He has previously worked in economist roles at the Federal Treasury, OECD and Macquarie Bank.

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