Following a 27% run this year, the S&P 500 is concerningly 20% overvalued, says a prominent chief investment officer. And wise investors should keep an eye out for early warning signs of trouble.
It's a paradox, though. The S&P 500 seems to only know one direction: Up. But the market's valuation continues to push into nosebleed heights. Big cap stocks are up 60% this year, while earnings rose just 16%, says Jack Ablin, CIO at Cresset Asset Management.
"How should investors approach a market in which valuation says 'sell' but momentum says 'buy?'" Ablin said. "Traditional valuation measures suggest the S&P 500 is currently more than 20% overvalued, yet trend-following measures, like momentum, remain strong."
Why The S&P 500 Looks Overvalued
Savvy investors compare the valuations of comparable assets for signs of bubbles. And doing so points to a richly valued S&P 500.
Ablin found the S&P 500's earning yield, which is its expected earnings divided by its price, is less than the yield of intermediate-maturity corporate bonds. The S&P 500 should trade for 20-times earnings based on this measure. But in reality it's trading for 25 times earnings, Ablin found.
But here's the rub. Pricey markets can — and often do — rise further still. That's why it's important for investors to have other ways of spotting overvaluation.
What Will Be The Tip Offs Of Trouble?
A fade in momentum would be a sign reality is catching up to the S&P 500. When the S&P 500's 50-day moving average slips below the 200-day, "momentum is negative," Ablin said.
"Momentum has been a useful directional S&P 500 trading tool," Ablin said. "The momentum indicator issued a sell signal in March 2022 and a subsequent buy signal in February 2023, helping avoid 11% of 2022's 18% downturn, yet allowing investors to capitalize on the 2023-2024 rally."
It's also wise to monitor any loss of support for high-momentum stocks. The Invesco S&P 500 Momentum ETF is up 49.3% this year, says Morningstar Direct. That makes it the top-performing actively traded U.S. diversified ETF. And the biggest holdings are Amazon.com, Nvidia and Meta Platforms, up 50%, 178% and 78%, respectively. If those stocks fade, that could be a sign of flagging momentum.
More Warning Signs
Nicholas Colas of Datatrek Research says three "usual suspects" and five less common triggers could turn markets bearish.
The usual suspects would be a geopolitical shock that pushes oil prices up, a halt in Fed rate cuts and worries about global growth.
And the less-likely problems would be an Enron-like corporate fraud, a blow-up with a key founder like Tesla's Elon Musk, a crash in crypto, global weakness due to a strong dollar or a further melt-up by stocks, Colas says.
Who knows if any of these events will happen. But S&P 500 investors are wise to weigh their options.
"With the 10-year S&P 500 expected return at around 5%, there are better alternatives," Ablin said. "The 10-year, BBB corporate bond, for example, offers investors a 5% annualized return if held to maturity — with meaningfully lower volatility."
Watch These Stocks
Largest positions in Invesco S&P 500 Momentum
| Stock | Ticker | Weight % | YTD % ch. |
|---|---|---|---|
| Amazon.com | AMZN | 10.6 | 50.4% |
| Nvidia | NVDA | 9.6 | 178.4% |
| Meta Platforms | META | 6.8 | 78.3% |
| Broadcom | AVGO | 5.8 | 62.5% |
| Berkshire Hathaway | BRKB | 5.7 | 41.8% |
