They know about the stretched valuations and everything that must go right to keep stocks aloft. And yet rather than shy away from frothy markets, plenty of investors are only now jumping in.
The reason, it appears, is how far out of the market they had been prior to the latest and greatest leg of the run-up, the one that began in March 2020. So long has it taken for risk appetites to recover, JPMorgan Chase & Co. research shows, that pushing it to the levels of past peaks could mean at least another 26% rally for the S&P 500.
“This bull market is still very young,” said Jim Paulsen, chief investment strategist at Leuthold Group, “It is not yet even one year old, and considering large US output gap and how high unemployment is, additional improvements in the economy should keep the stock market rising for a few more years.”
In the worldview of Paulsen and others, many of the things that look like impediments today, including high valuations, set the stage for improvement that could sustain a rally. After recessions in 1992, 2002 and 2009, they note, price-earnings ratios fall as growth resumed and stocks still managed to rise — in each case with the help of Federal Reserve stimulus.
Warnings that the market is ripe for a crash are getting louder as a 10-month, 70% rally has pushed the S&P 500’s price-earnings ratio to levels not seen since the dot-com era.
And while predicting the turning point is impossible, the study by JPMorgan suggests the end of the rally is likely a long way off. Strategists led by Nikolaos Panigirtzoglou developed a model to track investor holdings of stocks relative to bonds and cash over time. At 43.8%, the current equity exposure trails the peak of 50% seen before the 2007-2009 global financial crisis and is short of readings that were approaching 55% during the dot-com era.
By the team’s calculation, even a slight return to the last bull market peak of 47.6% — reached in January 2018 — would cause a 26% appreciation for the S&P 500.
“There is still room in the current bull market,” Panigirtzoglou said. “Admittedly, this room is created by still above-average bond allocations, rather than cash allocations which have already shifted to the low end of the past year’s range.”
Investors, who had shunned equities in favour of fixed income during most of the last bull market, are starting to warm up to stocks. In the final two months of 2020, equity funds attracted $190 billion of fresh money, a record high, according to data compiled Deutsche Bank. Still, that pales in comparison to the total outflows of $725 billion since the start of 2018.
The valuation case against stocks is poised to weaken. S&P 500 firms, climbing out of a pandemic-fomented recession, are in the process of ending a streak of profit declines, with income forecast to grow double-digit percentages this year and next.
“These are companies that are growing faster than general economic growth, command much higher multiples,” said Robert Zuccaro, founder of Target QR Strategies whose $50 million Golden Eagle Growth Fund surged 121% last year. “If you’re going to look at a historic multiple of 16 times that’s predicated upon an industrial society, you’re going to be out of the stock market when the market’s going up.”
Of course, much hinges on controlling the coronavirus. While the distribution of vaccines has boosted sentiment, a full recovery isn’t guaranteed. Yet young investors, some armed with money handed out in fiscal aids, are swarming to stocks and bullish options for quick profits.
The sign of froth, along with charts showing extreme momentum in benchmarks like the Russell 3000 Index, make Sam Stovall cautious. The chief investment strategist at CFRA Research recently received phone calls from his two nieces who have never invested in equities and now want to buy shares.
“This is like Markus Rudolf and Joe Kennedy looking to get advice from their bootblack,” Stovall said in an interview on Bloomberg Radio and Television. “That’s a concern that the market is need of a digest of gains.”
But that doesn’t mean an end to the bull market is looming. The average bull cycle has lasted about five years since the 1930s, with the shortest going on for at least two years.
“I wouldn’t sit here and say this is another year you could expect a 30 or 40% return but I’m optimistic this is going to be a good backdrop for risk-based assets for a least several more quarters,” said John Porter, head of equities at Mellon Investments. “It’s irrefutable how significant the Fed’s role is. And as an investor, you have to respect these forces in the market.”