Stocks ‘priced for perfection’ despite risks

Stocks have had a great year, but they’re priced for perfection as risks increase and strategists are turning cautious amid heightened geopolitical risks as the US election looms.

JBWere chief investment officer Sally Auld at their offices in Sydney. Picture: Ryan Osland

Strategists are turning cautious on stocks amid stretched valuations and heightened geopolitical risks as the US election looms. Some of the caution is coming from recent bulls.

Take Goldman Sachs chief US equity strategist David Kostin for example.

He’s been a consistent bull and recently upped his 12-month forecast for the S&P 500 to 6300 points, which implies a 7.6 per cent gain from current levels based on his forecast of 11 per cent earnings per share growth.

With the US stocks benchmark up 39 per cent over the past 12 months, investors would be happy enough with a further rise of almost 8 per cent as long as inflation remains under control.

But over the next 10 years, Kostin sees the S&P 500 giving an annualised nominal return of just 3 per cent or 1 per cent after inflation. That compares to an annualised 13 per cent total return over the past decade. His 10-year annualised return forecast for the S&P 500 would be 7 per cent higher if not for the “current high level of market concentration”.

In other words, he doubts that the tech giants can keep delivering such stellar share price growth.

Bloomberg’s “Magnificent 7” index is up 56 per cent in the past 12 months.

AI market leader Nvidia is up 229 per cent in the same period.

Traders on the floor of the New York Stock Exchange. Picture: Spencer Platt/AFP

Australia’s S&P/ASX 200 stock index remained under pressure on Wednesday, hitting a fresh two-week low of 8196.2 points after diving 1.7 per cent on Tuesday as bond yields continued to soar.

“Our forecast would be 4 percentage points greater than our baseline if we exclude a variable for market concentration that currently ranks near the highest level in 100 years.”

Kostin’s model of prospective long-term equity returns is also a function of the starting point valuation, economic contraction frequency, corporate profitability, and interest rates.

But his forecast would be 7 per cent higher if not for concentration risk.

“Our historical analyses show that it is extremely difficult for any firm to maintain high levels of sales growth and profit margins over sustained periods of time,” Kostin said.

“The same issue plagues a highly concentrated index.

“Furthermore, the risk embedded in high concentration markets is not always reflected in valuation.” He expects US stock market returns to broaden in the future.

Due to the “extremely-high market concentration” of the S&P 500, he expects the equal-weight benchmark (SPW) will outperform during the next decade by an annualised 2-8 per cent.

His forecast also suggests equities will face stiff competition from other assets.

With a 10-year US Treasury yield near 4 per cent and 10-year breakeven inflation of 2.2 per cent, his 3 per cent annualised equity total return forecast suggests the S&P 500 has a 72 per cent chance of trailing bonds and a 33 per cent chance of lagging inflation through 2034. Excluding concentration, the probabilities of underperforming would be just 7 per cent and 1 per cent, respectively.

In a similar warning, JB Were chief investment officer and head of investment strategy, Sally Auld told NAB’s Morning Call Podcast that US equities were “priced for perfection” after a great year.

The one-year forward price-to-earnings multiple of the S&P 500 is nearing 25 times, “which is pretty elevated relative to sort of medium term averages”.

And consensus forecasts of double-digit earnings growth for the next couple of years were relatively high. Auld also noted that the “equity risk premium” or yield advantage now offered by the S&P 500 versus “risk-free” Treasury bond yields was sitting at 20-year lows (apart from the Covid crisis).

With the 10-year US Treasury bond yield soaring to three-month lows above 4.20 per cent versus a 15-month low of 3.6 per cent on September 17th, the earnings yield of the S&P 500 has sunk to about minus 0.9 per cent. Australia’s S&P/ASX 200 dividend yield of about 3.5 per cent before franking credits now compares unfavourably to the 10-year bond yield of 4.46 per cent.

“So what it’s really telling you is that equity markets look really expensive, and we’re sort of at levels where it doesn’t feel like investors are necessarily getting compensated for the risk that they’re taking,” Auld said. “I think, in a nutshell, equity markets look expensive.”

While noting a lack of catalysts to sell stocks, she said investors “will probably look at the sort of return numbers and say that after such a great year for equities, it makes some sense just to take some chips off the table, rebalance the portfolio and just sort of wait, wait and see what happens.”

As for where to reinvest any profits taken in stocks, she said the money may flow to defensive assets like gold, but also to those that offered better risk-adjusted returns available.

“Gold is another one (defensive asset) that’s done phenomenally well,” she said. “It feels like everything that drives gold higher tends to be all happening at the same time at the moment.”

“It did just sort of makes sense, when you have markets that are really priced for perfection.”

“We’ve got growing trade protectionism, we’ve got these conflicts in various parts of the world…it doesn’t feel like an overly happy place at the moment. But you’d get a different, completely different conclusion if you looked at equity markets and their recent performance.”

Originally published as Stocks ‘priced for perfection’ despite risks