Wall Street’s record run raises a series of red flags

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With US stocks in record territory and the S&P 500 index the most richly valued in more than a decade, some investors see dark clouds gathering on the horizon.

The S&P 500, a broad measure of the stock prices of America’s largest companies, ended last week at a record high and has risen almost 10 per cent since the election of Donald Trump as president in November. Technology, healthcare, consumer discretionary, industrials and materials sectors have outperformed the broad benchmark since January.

Sam Stovall, chief investment strategist at CFRA, notes that less than two months into the year, the S&P 500 has already climbed above his year-end target of 2,335.

That has come even as earnings expectations for S&P 500 companies this year have become more subdued, with analysts expecting 2017 earnings per share of $130.31, compared with $131.02 in early December, according to S&P Capital IQ data.

“While our year-end target is indeed below the current level, we remind investors that during up years since 1945, the average closing high-low difference was more than 25 per cent and nearly 85 per cent of all up years endured a [year to date] decline at some point along the way,” he said.

Beneath the surface of the S&P’s record run an ominous statistic also lurks. The index’s forward price-to-earnings ratio has climbed to 17.6 times, the first time the key valuation metric has risen to that level since 2004, and above the average over the past 20 years of 17.2, according to FactSet data.

While Wall Street analysts note that expanding valuations alone are typically not enough to derail a market advance, there have also been other indications of potential turbulence ahead.

“We continue to believe a near-term S&P pullback of the 5 per cent to 7 per cent variety is likely,” said Peter Cecchini, chief market strategist at Cantor Fitzgerald.

Mr Cecchini pointed to several potentially worrisome factors. While the S&P 500 has set a series of new highs, the record pace has slowed while slumbering implied volatility, leaving expectations among options traders for tumult over the next three months.

Another point of concern, Japan’s Nikkei 225 index, has also stalled since the start of the year, rising 0.7 per cent compared with the S&P 500 which is up 5 per cent.

The Nikkei “peaked ahead of tops in the S&P in 2000 and 2007,” said Mr Cecchini. “Keep in mind, the S&P is usually the last risky asset that market participants sell”.

Goldman Sachs strategists have a muted view for US stocks. The investment bank expects the S&P 500 to climb further over the next three months to 2,400, but then pull back to 2,300 over the following nine months — which would represent a price decline from current levels of about 2 per cent.

The Goldman strategists flag numerous risks to stocks globally, including “growth momentum slowing, disappointments in US policy, rates rising too far too fast, and European politics”.

“While we do not think any of those risks are imminent, we remain overweight cash in our asset allocation — over both three and 12 months — in order to hedge,” they said.

US equities bourses were closed on Monday for President’s Day.

Adam Samson in New York

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