US stocks too strong? Wall Street warns: may face "lost decade"

The unexpected rise in the US stock market this year has surprised Wall Street strategists.

According to the Securities Times app, the S&P 500 index hit a new high at the close of last week, with a cumulative increase of 23% since the beginning of the year. In January, strategists predicted that the S&P 500 index would remain flat for the year. Despite repeatedly raising their expectations, the performance of the S&P 500 index has exceeded expectations.

The S&P 500 index continues to surpass the expectations of strategists

This is to some extent related to the US economy. The job market has performed much better than expected, and inflation seems to be under control. Interest rates are high but are decreasing. The benefits of the artificial intelligence boom have not been fully priced in as of January. However, the political uncertainty in the United States is well known, and reliable long-term indicators suggest extreme caution is warranted.

Wall Street strategists believe that the valuation of the S&P 500 index is becoming increasingly high, squeezing further upside potential. David Kostin, Chief US Equity Strategist at Goldman Sachs, made a noteworthy dual forecast. On October 4th, he raised his year-end forecast for the S&P 500 index from 5600 points to 6000 points and set a 12-month target of 6300 points, implying an increase of about 11% within a year. Last week, he published a follow-up research report, suggesting that the S&P 500 index is expected to have an annual nominal increase of only 3% (1% in real terms) over the next ten years, making it one of the worst increases on record.

This is not entirely contradictory. Bloomberg columnist John Authers stated that a market that is already strong is expected to perform well in the next 12 months but poorly over the next 10 years, which indeed suggests an unstable market that may even experience a bubble. Authers analyzed the market-driving factors.

Sentiment

In the short term, the market is a product of what Keynes called "animal spirits." The situation is clearly developing in a bullish direction, making it difficult to stop in the short term. The global large fund management companies surveyed by Bank of America last month saw the largest reduction in bond allocations in 23 years:

Excitement about stocks is evident, with stock allocations seeing the largest increase since the first lockdown in 2020:

The stock market's strength often has a positive feedback loop on the economy. With the rise of the S&P 500 index, people's optimism about the continued growth of the U.S. economy in the next 12 months has increased. All of this is in line with the market's growing belief that Donald Trump will return to the White House. Trump's victory in the U.S. election is seen as bullish for the stock market and bearish for bonds.

Another important short-term factor is earnings season, which also suggests that investors should not exit the stock market. Profit forecasts are relatively unchallenging, and Goldman Sachs' Kostin team estimates that profit margins can continue to expand. Goldman Sachs' expectations for the U.S. economy are also slightly better than the market's general expectations, providing a reason for the strong performance of the stock market next year.

Valuation

In the long run, valuation is the most important factor. The higher the price when buying stocks, the less return will be obtained over ten years or longer. However, this relationship does not hold in the short term, and investors cannot use it to time the market. An irrationally expensive market will always become even more expensive. But over ten years or longer, this relationship will hold. This is the core reason why Goldman Sachs and other institutions are quite pessimistic about their long-term forecasts for U.S. stocks.

The most widely used long-term valuation measure is CAPE (Cyclically Adjusted Price-to-Earnings ratio), which was first proposed by legendary value investor Benjamin Graham in the 1930s and popularized 25 years ago by Nobel laureate Robert Shiller in the book "Irrational Exuberance." The key to this indicator is that valuation will be adjusted according to the economic cycle, with higher multiples when the economy is in a downturn but may improve, and vice versa.

U.S. stock valuations appear to be at historical highs

With the growth of profitability and productivity, CAPE will rise over time. However, it is unsettling that the S&P index is more expensive than on the eve of the 1929 Great Crash and not much cheaper than during the bursting of the dot-com bubble in the early 2000s. Perhaps more importantly, after reaching a peak in the past, CAPE sharply declined within a few years. This time is different, as CAPE peaked during the prosperity period after the 2021 pandemic but rebounded by the end of 2022. Coincidentally or not, this rebound coincides with the launch of ChatGPT. The AI frenzy seems to play a crucial role in maintaining market highs.

Stock valuations should not be disconnected from bonds. Lower bond yields prove that paying higher prices for stocks is reasonable. According to Shiller's "Excess CAPE Yield," the lower a stock's excess yield, the worse its subsequent performance relative to bonds. The two times the excess CAPE yield turned negative (meaning stocks were more expensive than bonds) coincided with the Great Crash and the dot-com bubble, which were the two best opportunities in history to exit the stock market The long-term outlook for the US stock market is not optimistic.

But strange things are happening. Currently, the actual return on stocks exceeds expectations by the largest margin since the 19th century. The most reasonable explanation is the special monetary stimulus during the pandemic. However, the most important thing is that reliable indicators show not to expect stocks to outperform bonds, as the recent high returns on stocks seem abnormally high. Artificial intelligence and stimulus plans have played a significant role in supporting the stock market rally, but there are reasons to expect their impact to gradually diminish.

Currently, the US market appears much more expensive than other developed markets. However, this is not always the case: during the peak of the internet bubble, stock markets in several countries were more expensive than the US, even though the center of the wave (like artificial intelligence) was clearly in the US.

The US stock market is not always more expensive than other markets.

The above analysis is not suggesting that investors should sell US stocks now. But looking ahead 10 years, US stocks are expected to underperform stocks in other countries and not perform well compared to bonds. The significant influence of the "Big Seven" including Apple (AAPL.US), Amazon (AMZN.US), Microsoft (MSFT.US), Nvidia (NVDA.US), Alphabet (GOOG.US, GOOGL.US), Meta (META.US), and Tesla (TSLA.US) may be a core reason.

Concentration

Undoubtedly, the US stock market (and even global stock markets) is exceptionally concentrated. Kostin found that concentration is at the 99th percentile in history, which is significant: when market concentration is high, the performance of the overall index largely depends on the prospects of a few stocks. In a highly concentrated market environment, index volatility may be greater.

Here is the share of the largest 10 stocks in the S&P 500 index since 1980:

Kostin pointed out that concentration affects valuation. Excluding the top 10 stocks, the return of the S&P 500 index is higher than the 10-year US Treasury bond; while the returns of the top 10 stocks are also declining, which should be a strong sell signal:

Authers concluded that generally, the strategy of only buying the largest stocks is doomed to fail, as these stocks have no other way to go but down, and their competitive positions will gradually be eroded. Even excluding the impact of large-cap stocks, it is still difficult to make a positive forecast for the US stock market in the next 10 years. However, it appears that the stock market will continue to rise for now, so investors should proceed with caution