As Investors Ignore Growing Risks, the Stock Market is Poised for a Meltdown

As the S&P 500 continues to reach record highs, a common question arises: Are we witnessing a stock market "melt-up"? To define a melt-up, one simple approach is to observe the S&P 500’s forward price-to-earnings (P/E) ratio rising much faster than its forward earnings per share. This suggests increasing “irrational exuberance,” a term famously coined by then-U.S. Federal Reserve Chair Alan Greenspan in his 1996 speech. Greenspan asked how one could identify when irrational exuberance had inflated asset values to the point of being vulnerable to sudden and extended contractions.

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In a stock market bubble, investors generally harbor overly optimistic expectations for earnings growth while underestimating risks. This combination can justify the elevated market valuations, even if these assumptions are not based on rational analysis. Such a scenario can lead to a melt-up, where stock prices surge, only to be followed by a meltdown or significant market correction. The question now is: Are we in the midst of this phenomenon? It is difficult to pinpoint definitively, but signs suggest we might be inching closer to such a scenario.

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One striking aspect of the current market environment is the seeming disregard for geopolitical and domestic political risks. For instance, tensions in the Middle East have escalated recently. Hezbollah's attempt to assassinate Israel's prime minister over the weekend has raised the stakes, following Iran’s missile attack a few weeks prior. Israel’s expected retaliatory response could further destabilize the region.

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Meanwhile, in the United States, the approaching presidential election introduces its own set of risks. If the election results are tightly contested, it could lead to significant political instability. Alternatively, a decisive victory for either party might result in legislative efforts that drive inflation and increase the national deficit, particularly if the policies adopted are extreme. Given these potential risks, a period of political gridlock might actually be the more favorable outcome.

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Looking at the numbers, the current bull market, which began on October 12, 2022, has seen the S&P 500’s forward P/E ratio increase by 43%, rising from 15.3 to 21.9 as of mid-October 2023. In contrast, forward earnings per share have grown by only 13.9% over the same period.

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This disparity between P/E growth and earnings growth raises concerns about sustainability. The forward P/E ratio is also inversely correlated with the Misery Index, which combines the unemployment and inflation rates. At present, the Misery Index is historically low, which, while it has not done much to boost consumer confidence, has certainly bolstered investor sentiment.

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However, the forward P/E ratio is now approaching levels seen during the previous two cyclical peaks in January 2021 (22.6) and July 1999 (25.5). A significant factor contributing to this trend is the S&P 500’s Information Technology sector, which includes heavyweight stocks like Apple, Microsoft, and Nvidia. The forward P/E ratio for the tech sector is currently 28.9, significantly lower than the 55.5 level seen during the tech bubble in March 2000. Still, it remains relatively high compared to other sectors.

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Another interesting observation is the tech sector's current dominance within the broader S&P 500. It now accounts for 32.2% of the market capitalization, roughly equivalent to the sector's peak during the 1999-2000 tech bubble.

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However, there is a crucial difference this time: the earnings generated by the tech sector are now much stronger and more sustainable than they were in the late 1990s. Back then, the sector contributed less than 18% of the S&P 500’s earnings, while today it accounts for 24.2%. This suggests that the tech sector is better positioned for long-term growth and less prone to the unsustainable practices of the past.

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Overall, the U.S. economy remains on a solid growth trajectory, which should continue to support earnings for companies within the S&P 500. The primary concern regarding the current high valuation multiples is not earnings growth but rather the potential impact of adverse geopolitical and political developments, particularly as the year comes to a close. If these risks materialize, the market is more likely to experience a correction rather than a full-blown bear market.

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Given this outlook, the year-end target for the S&P 500 remains set at 5,800. Looking ahead, the forecast for next year is even more optimistic, with a target of 6,300. Despite the potential risks, the fundamentals appear strong enough to justify continued growth in the stock market. However, it is essential to remain vigilant as external factors, particularly in the geopolitical and political spheres, could still pose challenges that may lead to market volatility in the months ahead.

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