As hard as stocks plunged last quarter, their recovery in the New Year has been just as swift. A warning to S&P 500 bulls getting used to the upward trajectory: This is where rallies have fallen dead in the past.
While valuation makes a poor tool for market timing, there’s evidence its force becomes felt when the benchmark starts to approach 2,800. It’s 25 points from that level now, after vaulting 18% since Christmas. More ominously for bulls is the sudden squishiness of 2019 profit estimates. It’s tough to fashion a case for more gains when the foundation keeps sagging.
Amid a winter of renewal, the question has lingered – when does shifting sentiment alone become too little to move the market? After all, an 8,000-point round trip in the Dow Jones Industrial Average has taken place since September with nary a ripple in readings on growth. At some point fundamentals will reassert themselves. Some say the time has arrived.
“You’re going to have to see the fundamentals support higher markets and those fundamentals are not great right now,” said Chris Gaffney, president of world markets at TIAA Bank in St Louis. “It’s absolutely dangerous.” While the S&P 500 advanced 2.5% in the past five days to cap its seventh weekly gain in the past eight, the index’s next leg up would have it confront the round-number milestone that’s marked the demise of three prior rallies since October.
One explanation for the skittishness is valuation. If the S&P 500 tops 2,800, its valuation based on 2019 average per-share earnings estimates will be 16.5 times forward earnings – that’s the average reading over the past five years, demarcating a level at which some analysts say stocks become expensive.
Worse for bulls, earnings estimates continue to come down, tugging lower the index level at which the S&P 500’s forward profit multiple poses a problem. After one of the strongest years for earnings during the record bull run, companies are expected to post negative year-over-year growth in the first quarter of 2019. That would be the first contraction in three years. Minuscule profit growth is slated to follow in the next two quarters.
“I think a lot of people are saying, do I really want to pay above the average P/E when I’m not sure that the E part of the P/E is going to stay up?” said Matt Maley, equity strategist at Miller Tabak + Co. “When you have a market that’s rallied so much in just six weeks, when you start getting close to a resistance level, people get nervous.”
Market technicians including BMO Capital’s Russ Visch also say 2,800 is critical for the index’s further gain after breakout attempts ended near 2,810 in October, 2,814 in November and 2,790 in December. He says the index would have to rise past those numbers before it can make a meaningful run at new records.
“Only a close above multiple resistance levels in the 2,800-2,815 zone would make us rethink the call for a re-test,” Visch said. “Realistically, we don’t see that happening given the deterioration in short-term breadth and momentum gauges.”
Despite that, the S&P 500 climbed 6.9% in the five weeks since the earnings season kicked off, the best start to any reporting period since the results came in for the third quarter of 2014.
Certainly, the Federal Reserve has a lot to do with the advance. Chairman Jerome Powell’s move to a more dovish stance in January helped the market rebound after plunging as much as 20%.
That rout was partly caused by the central bank’s comment in October that the monetary policy is a long way from neutral.
To strategists like Morgan Stanley’s Mike Wilson, the Fed’s more dovish stance alone is not enough to support the markets when political headwinds mount and economic data show few signs of improvement. Retail sales posted the largest drop since 2009 and initial jobless claims came in higher than estimated just this week.
“Don’t get caught up in the price momentum, as if the market is telling you something that may happen,” Wilson, the bank’s chief US equity strategist, said on Bloomberg TV. “The data isn’t improving, and the data probably isn’t going to improve over the next two to three quarters, and that’s going to create uncertainty again when you’re trading at 2,750-2,800.”
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