All good things must, eventually, come to an end.
In recent days the S&P 500 has marginally sold off, but with the index still up roughly 75% from the market bottom hit nearly a year ago, some on the Street are starting to get antsy.
As CFRA’s chief investment strategist Sam Stovall puts it, “It’s not a question of ‘if’ but ‘when’ the next meaningful market decline will occur,” he wrote in a Monday note.
That’s because there are now multiple indicators signaling a pullback is due.
“The bears are getting louder,” Lindsey Bell, chief investment strategist for Ally Invest, suggests to Fortune. That’s in part because, as Bell notes, the S&P 500 is “stretched” above its 200-day moving average, even more so than stocks were during the September 2020 peak before selling off.
But that’s not necessarily bad. “In the near term, pullbacks are a healthy component of market activity, so I don’t think that would be necessarily a terrible thing,” she says, suggesting a 5% or 10% pullback might be in order.
One thing the Street has been eyeing as a “catalyst for the much-anticipated correction,” notes Stovall, is the recent talk of rising inflation coupled with stronger-than-expected retail sales data and producer price index readings. Indeed, on Monday, the 10-year Treasury yield hit over 1.3% while stocks (sans the Dow) sold off.
While improving data is good for the economy and overall recovery, “for equity valuations, higher rates would reduce the justification for multiples that are extremely elevated in absolute terms but attractive relative to bond and cash yields,” analysts at Goldman Sachs wrote in a Feb. 12 report. (Still, they note that it’s possible that stocks can “rise alongside higher interest rates as long as the rise in rates is orderly and driven by growth.”)
Meanwhile, investors are still fixated on lofty valuations. Next 12 months price/earnings ratios are far above historical averages. Stovall notes “all sectors in the S&P 500 but health care trade at double-digit premiums to their 20-year average NTM P/E ratios,” with the S&P 500 currently trading at close to 23 times forward earnings (for context, see FactSet’s chart, which was tweeted on Sunday). That’s actually down a bit from last year, thanks to a strong fourth-quarter earnings season, but still expensive by historical standards.
Morgan Stanley’s chief investment officer, Lisa Shalett, wrote in a Monday note, “Every asset class index that we follow [is] now in the top 5% of valuation for the last 20 years,” while “the Buffett Indicator, which is the ratio of total U.S. stock market capitalization to GDP, now registers 147%, dwarfing the prior high of 127% reached in 1999.”
All of the recent bullishness and high valuations have made some strategists anxious about “frothy” market sentiment and margin debt levels—when investors borrow money to buy or short stocks. Margin debt is “also at an all-time high, whether compared with the S&P 500 or nominal GDP,” notes Stovall. “People are much more willing to borrow to make bets if in fact they’re confident about the outcome,” Brad McMillan, chief investment officer at Commonwealth Financial Network, told Fortune last week. That rising level of margin debt, “to me, reflects an unhealthy level of positive expectations,” he said.
Elsewhere, CFRA’s Stovall also points to the longtime divergence between growth versus value: He notes the “rolling 12-month price change for the S&P 500 growth index minus that for the value index hit an all-time high in Q3 2020, and remains at a level not seen since the early months of the 2000–02 bear market.”
All of that is to say that markets may need to cool off soon—though, as plenty of strategists will tell you, there’s much to be optimistic about in the long run.
What not to do
There’s a common (and here, paraphrased) expression on the Street to describe investor behavior during a selloff: Markets are the only place where, when there’s a sale, people run out of the store.
That’s the kind of reaction those like Stovall hope investors will avoid. “History reminds us that selloffs should be viewed as annoyances to be prepared for, not overreacted to, and that every pullback, correction, and bear market has eventually recovered,” he writes. (To drive that point home, see CFRA’s chart, showing bull markets vastly outnumber periods of selloffs.)
Investors should therefore focus on “not letting their emotions become their portfolio’s worst enemy by selling, likely near the bottom,” suggests Stovall.
Instead, those like Ally’s Bell are optimistic about the overall course of markets for the rest of the year. She argues that 2021 earnings estimates might still be too low, providing room for upside; that consumer savings rates are higher and debt is lower; and the consumer will fuel the release of pent-up demand as the economy recovers later in the year.
That’s why, Bell adds, “any sort of pullback would most likely be a buy-on-the-dip type of opportunity.”