To The Moon

$.SPX(.SPX)$ $SPDR S&P 500 ETF Trust(SPY)$ $NASDAQ 100(NDX)$

Several prominent analysts foresee a strong finish for the S&P 500 Index (SP: .INX) over the next two years, offering potential gains for those interested in U.S. equities.

The S&P 500 Index, the primary gauge of U.S. stock market performance, reflects the top 500 companies by market capitalization, as well as criteria like earnings growth and trading liquidity.

Goldman Sachs' chief U.S. equity strategist, David Kostin, recently raised his S&P 500 target following an impressive earnings season, setting a new goal of 6,500 by the end of 2025. This represents a potential 10% increase from the current level of 5,916.

This positive outlook is favorable for the SPDR S&P 500 ETF Trust (ASX: SPY), which tracks the index. Kostin’s optimism is grounded in expectations for ongoing U.S. economic expansion, steady corporate earnings growth, and stable bond yields.

Market Sentiment

As of November 2024, sentiment around the S&P 500 is marked by a mix of optimism and caution. Investors' confidence has been buoyed by robust U.S. economic indicators, including strong employment growth and resilient corporate earnings. Recent data from S&P Global reveals that risk appetite has surged post-election, with investor sentiment reaching its most optimistic level since early 2021. This shift in attitude was influenced by the removal of political uncertainty, which has created a short-term "honeymoon phase" for U.S. markets, where investors anticipate continued gains into early 2025.

The bullish sentiment surrounding the S&P 500 has been notably strong, driven by several key factors.

High Investor Confidence and FOMO

Bullish sentiment is also influenced by high investor confidence and the “fear of missing out” (FOMO) on continued gains. Surveys like the American Association of Individual Investors (AAII) report elevated levels of optimism among retail investors, who expect stock prices to rise in the coming months.

Fed’s Rate Pause and Potential Cuts

The Federal Reserve’s recent pause on interest rate hikes, along with the possibility of rate cuts in the near future, has bolstered investor sentiment. Lower rates tend to support higher stock valuations by reducing borrowing costs and making stocks more attractive relative to bonds.

S&P 500 valuation

The S&P 500’s forward price-to-earnings ratio is still above its historical averages, indicating potential vulnerability if economic conditions or interest rates shift unexpectedly​.

While Wall Street analysts are tempering their upbeat forecasts with caution, investors are leaning increasingly bullish. According to the latest survey from the American Association of Individual Investors (AAII), 49.8% of respondents now expect stocks to rise over the next six months—a level considered "unusually high." Since AAII began tracking sentiment in 1987, bullish readings above 50% have only occurred about 10% of the time.

Asset managers, meanwhile, may hesitate to rein in this enthusiasm. Even if they anticipate a market correction, timing it accurately is notoriously difficult, often owing more to luck than to any fundamental or technical analysis. The fear of missing out (FOMO) remains a potent force, capable of sustaining market optimism longer than fundamentals might suggest.

In investing, calling a downturn too early risks making one appear overly cautious, if not misguided. Fund managers may find it challenging to advise reducing exposure in a market on a prolonged uptrend. As former Citi CEO Chuck Prince put it in July 2007, as warning signs emerged in the leveraged buyout market, "As long as the music is playing, you've got to get up and dance. We’re still dancing."

Price-to-Earnings (P/E) Ratio

Current P/E: The S&P 500’s price-to-earnings ratio often serves as a go-to measure for valuation. Currently, the forward P/E (based on projected earnings for the next 12 months) is around 19-21, which is above its long-term historical average of around 16.

Implications: A high P/E ratio can indicate high investor confidence but also suggests that stocks are more expensive relative to earnings, potentially pricing in a very optimistic future.

2. Cyclically Adjusted Price-to-Earnings (CAPE) Ratio

Dangerous Zone

What It Is: The CAPE ratio, also called the Shiller P/E, smooths out earnings over a 10-year period adjusted for inflation. Historically, the CAPE ratio has averaged around 17.

Current CAPE: As of late 2023, the CAPE ratio is over 30, signaling that the market could be overvalued relative to its historical norm.

Implications: High CAPE values have historically been associated with lower forward returns, though this is not a guaranteed predictor.

Market Cap-to-GDP (Buffett Indicator)

What It Is: The ratio of the total market capitalization to GDP is sometimes referred to as the “Buffett Indicator.” A ratio over 100% suggests that the stock market might be overvalued relative to the economy.

Current Reading: Recently, the Buffett Indicator has been significantly over 100%, indicating a overvaluation. The historical average has ranged closer to 75-90%.

Implications: This measure suggests the market could be detached from underlying economic fundamentals.

Corporate Debt Spread

Yield Spreads: The yield spread between corporate bonds (both investment and junk grade) and Treasuries has narrowed significantly, suggesting increased risk appetite among investors.

Risk: Historically low yield spreads indicate a strong market but can also be a signal of complacency, as investors are accepting lower compensation for riskier assets.

Sector Composition and Concentration

Impact of Tech and AI: A significant portion of the S&P 500’s market cap is concentrated in a few high-growth tech and AI companies, including Microsoft, Nvidia, and Apple. These stocks have higher-than-average P/E ratios, which elevates the index’s overall valuation.

Concentration Risk: The S&P 500 is now more sensitive to performance in these sectors. This makes the index vulnerable if there’s a downturn or reevaluation of tech and AI valuations.

Even bullish investors now acknowledge that U.S. stocks and credit are highly priced. Many believe that the positive macroeconomic outlook will keep the momentum going into next year, though they caution that an eventual downturn is likely—just not immediately. Wall Street’s three main indices hit record highs last week, extending the remarkable rally that began over a year ago. Since the Fed’s shift away from rate hikes last October, the Nasdaq has climbed over 50%, and Nvidia’s stock price has soared by 250%, making it the world’s largest company.

The S&P 500 is also on track for one of its strongest calendar-year performances since 1928. At the same time, the yield spreads between investment- and junk-grade corporate debt and Treasuries have tightened to historically low levels, in some cases reaching record lows. There’s no foolproof way to measure a market's overvaluation, but by most standards, these are cautionary signals.

&P 500 having one of its best calendar years since 1928

Conclusion

The S&P 500 appears overvalued by most traditional metrics, driven largely by the strength in tech and optimism about economic resilience. High valuations suggest that forward returns could be muted, with increased vulnerability to economic or earnings shocks. However, these elevated levels may persist if the economy avoids recession and corporate earnings continue to grow.