Stretched Valuations, Interest Rate Expectations, Make Stocks Vulnerable To Sell-offs

Stretched valuations and diminished expectations of interest rate cuts make U.S. equities vulnerable to sell-offs, David Bahnsen, chief investment officer of The Bahnsen Group, said.

"Valuations are so stretched right now that anything less than perfection from economic data or geopolitical noise can create substantial and quick selloffs," he told International Business Times. "This market touchiness should not be confused with directional weakness, which we are not seeing right now, as markets have been strong all year despite substantial changes in Fed rate cut expectations and a mixed bag of returns for last year's so-called Magnificent 7."

Marc Dizard, CFA, CFP, Chief Investment Strategist, PNC Asset Management Group, agrees. "The market is nearly priced to perfection, leaving more downside risk than upside opportunity," he said, adding, "Valuations themselves won't be the catalyst but can act as an accelerant to a drawdown pushing into a correction."

Dizard points to the current multiple of nearly 21x the next twelve months' earnings. It's above the historical norm and even more stretched for some large caps that have fueled most market gains in the last year.

He sees good news and not-so-good news in this pattern. "The good news is those companies have had earnings growth to back up the overly stretched valuations so far; the not-as-good news – is that earnings growth looks to be slowing throughout the year," he explained. "Toss into the mix a 'higher for longer than expected' monetary policy, companies with interest rate sensitive expenses could find themselves vulnerable to investor expectations and repricing."

Dizard believes a correction is in the future, but he doesn't try to time it. Instead, he advises caution for the investment community. "When we see valuations stretched, we exercise caution within investment allocations and pay close attention to sentiment," he elaborated. "While any correction isn't pleasant, it would act as a healthy reset at this point, with the S&P 500 up by over 25% since the end of October."

Richard Saperstein, Treasury Partners' chief investment officer, blames investor enthusiasm for AI and inflation resilience for the problematic situation of U.S. equities. Moreover, he believes this situation puts more pressure on listed companies to deliver solid earnings, the next catalyst for market gains.

"Markets have been fueled by AI exuberance, declining inflation, and the prospect of rate cuts, but the recent resiliency of inflation reduces the immediacy of rate cuts, which puts more pressure on earnings to drive future market gains," he said.

Bahnsen sees earnings as one of the catalysts for the market direction. "With stock valuations near record highs, the burden is on earnings to drive further stock price rises," he stated. "Wall Street is expecting 10% earnings growth in both 2024 and 2025, which may not be enough fuel to drive any meaningful stock market gains from current levels."

The other could be interest rate cuts. "We expect 3-4 rate cuts for the simple reason that the Fed funds futures market expects this many cuts, and the Fed has gone out of its way to wink and nod in agreement with the market's expectations," Bahnsen continued. "The Fed would like some softening inflation data cover that provides a talking point before they cut interest rates to soften any unfair accusations of eventual cuts being political since we are in a presidential election year."

Fed officials will closely monitor two inflation reports, the Consumer Price Index (CPI) and the Producer Price Index (PPI), to determine whether inflation is softening or hardening.

Meanwhile, Bahnsen sees another reason for the nation's central bank to stick to rate cuts: the maturity of massive corporate and commercial real estate debt coming up by the end of 2025. "The Fed has ample incentive, even with low unemployment and good GDP growth, to get rates lower before the end of the year," he added.

Still, Arnim Holzer, Global Macro Strategist at Easterly EAB Risk Solutions, believes investors shouldn't try to time a market pullback. Instead, they should have the right portfolio to prepare for the prospect of it.

"While there are certainly reasons to worry about equities here, we think the more important issue is getting portfolio diversification right in case it does occur," he said. "Timing can be difficult to get correct. We think investors will be better off in that way than trying to time a pullback in equities."