By William Watts
Stretched valuations and optimistic earnings growth expectations leave equities vulnerable: CIO
Cancel your Wednesday appointments.
Stock-market investors are in for a double whammy on June 12, with the May consumer-price index due for release at 8:30 a.m. Eastern followed by the conclusion of the Federal Reserve's two-day policy meeting at 2 p.m.
CPI days and Fed days have individual reputations for market volatility. The good news, perhaps, for investors is that they won't have to wait long for Fed Chair Jerome Powell to provide some guidance on what central bankers think of the May inflation data.
Policymakers are seen as almost certain to leave interest rates alone when the two-day meeting concludes, but it will be the outlook on when they expect to deliver seemingly elusive rate cuts that will be in focus.
Check out: Fed won't move interest rates this week, but meeting will still be a feast for economists
Investors came into 2024 expecting six or even seven quarter percentage point reductions beginning in March. Several hotter-than-expected inflation readings and jobs reports, including Friday's May employment data, now have fed-funds futures traders pricing in two at best, perhaps beginning in September.
See: How Wall Street hopes for multiple Fed rate cuts this year came undone
Stocks, however, have rallied even as rate-cut expectations have faded. Resilient economic data has sparked confidence in robust earnings growth this year and next.
And that's what worries some investors, who contend the rally leaves stocks priced for perfection and vulnerable to disappointment.
The forward 12-month price-to-earnings ratio for the S&P 500 is 20.7, according to FactSet, above the five-year average of 19.2 and the 10-year average of 17.8.
"Equity valuations are expensive today and this really needs to be an earnings growth story going forward," said Josh Emanuel, chief investment officer at Wilshire, in a phone interview.
There's little margin for error with Wall Street penciling in earnings growth of around 25% for the S&P 500 over the course of 2024 and 2025, he said.
While the May jobs report sparked a selloff in Treasurys that lifted yields, equities held their own during most of Friday's session, with the S&P 500 SPX and Nasdaq Composite COMP threatening to end at records before a late-day pullback left them with small losses.
Friday's data showed the U.S. created a bigger-than-expected 272,000 new jobs in May, suggesting the economy is still fairly strong and reducing the chances the Federal Reserve will cut interest rates soon. The unemployment rate, however, rose to 4% from 3.9%, the first time it's hit that mark since January 2022.
Perhaps most troubling for Fed policymakers, average hourly earnings grew at a 4.1% year-over-year rate, up from 4% in April. The Fed wants to see growth closer to 3% as it attempts to bring down inflation.
Nevertheless, the Dow Jones Industrial Average DJIA eked out a weekly gain of 0.3%, while the S&P 500 rose 1.3% and the Nasdaq booked an advance of 2.4%. The S&P 500 is up more than 12% so far in 2024, while the tech-heavy Nasdaq has rallied over 14%. The more cyclical Dow is up just 2.9% year to date.
Read: Stock market's records belie the cracks forming beneath the surface
Technology stocks, of course, have remained the big story of 2024, with Nvidia Corp. (NVDA) last week joining the $3 trillion market capitalization club. The S&P 500 equal weight index, which as the name implies treats all its constituents equally rather than weighting them by size, is up just 4.3% so far this year, testifying to the influence of megacap tech highfliers.
Also read: Three stocks now account for 20% of the S&P 500's value. That's making some investors nervous.
While the Treasury market recalibrated after the jobs data, pushing yields higher, stocks need to follow suit, Emanuel said.
Rising Treasury yields can unsettle stocks, particularly if the rise is rapid. Higher yields imply higher borrowing costs but, more important, can make equities less attractive relative to bonds as they pay more attractive yields than was previously the case.
Emanuel argued that while rate markets have behaved more rationally in response to economic data and reduced prospects for rate cuts, "equity markets and risk assets have shrugged this off based on the idea that equities will outgrow that valuation headwind coming from higher interest rates."
That's going to be hard to accomplish when earnings growth is already very strong, investor sentiment is positive, economic sentiment is no longer pricing in a recession and investors portfolio exposure to equities is increasingly stretched," he said. "The setup creates a very challenging environment for equities to outpace expectations."
There's a risk Powell sounds hawkish relative to expectations, but the bigger test will come during the next earnings season, when results will need to meet rising expectations, he said. Meanwhile, markets ma prove more volatile.
See: Fed won't move interest rates next week, but meeting will still be a feast for economists
As far as Wednesday goes, much attention will be paid to the central bank's policy statement, remarks by Powell and an update to the central bank's Summary of Economic Projections, also known as the "dot plot."
The dot plot reflects individual policy expectations among Fed officials. Investors will want to see how many rate cuts they're pricing in. The last dot plot, issued in March, showed policymakers, overall, looking for three quarter-point cuts in 2024.
"We think Powell is likely to continue downplaying any speculation about further rate hikes, as we see no signs of the economy overheating," said Antti Ilvonen, senior analyst for U.S. macro at Copenhagen's Danske Bank.
" Sticky inflation could continue to push cuts further into the future, but current level of interest rates is still likely seen as restrictive enough," he said. "This could again be a dovish signal for markets."
-William Watts
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06-10-24 0659ET
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