In late May, JP Morgan’s Marko Kolanovic defended his stubborn, negative stance on the U.S. stocks, asserting that the S&P 500 was substantially overvalued, and predicted that the big cap index would end the year at 4200, down 24% from its level at the time. By then, Kolanovic was the last bearish market strategist at a major Wall Street bank; all the others, even the previously dour ones, were predicting more gains by year end on the view that the fabulous resurgence that started in early 2023 would just keep rolling.
Kolanovic had also been wrong in 2022 when he foresaw great things for equities, and the markets tanked. It appears that missing by a wide margin on back-to-back forecasts, over two-and-a-half years, cost him his job. But does his analysis of the market’s fundamentals was wrong? Not at all.
In fact, the circumstances surrounding his departure carry two lessons. First, extremely short-term calls on the direction of equities are worthless. Second, history shows that episodes of inflated prices can go on a long time—but that the gravitational forces that govern earnings growth and PE multiples over extended periods always eventually take hold, and carry the day.
Despite the great bull run and the exit of skeptics like Kolanovic who so far got it wrong, equities do look dangerously pricey
In his most recent report, Kolanovic stated that stock prices were simply incorporating much higher earnings growth than he deemed reasonable. It’s a good argument. For Q1 of this year, S&P 500 net profits, based on the last four quarters, stood at $192. That’s 38% higher than the pre-pandemic record of $140 set at the close of 2019. The famous CAPE model developed by Yale economist and Nobel laureate Robert Shiller strongly implies that the $192 number is unsustainable, and that a “baseline” for earnings is more like $155.
The rub: Even though profits hover at extremely lofty levels, what investors are paying for each dollar of those possible unrepeatable earnings is also immense. The S&P’s current multiple stands at 28.9. Except during the Great Financial Crisis when profits collapsed, that’s the highest PE for any quarter since the tech bubble of the late 1990s and early 2000s. And over the past 36 years, the S&P’s PE has only been that high for just five months, all during this century’s most notorious craze.
That episode is a reminder that prices can break free of anything justified by the basics for years, so while that’s happening, predictions of an imminent fall are always wrong—until they’re finally and inevitably right. Put simply, though the outcome’s predictable, the timing is anything but. By June of 2017, the Shiller model was flashing red, indicating that that the S&P had swung into the super-rich zone. Yet through August of 2000, a stretch of over three years, the index gained another 79%, rising from 847 to 1517. By February of 2003, the S&P made a virtual round trip to 841, and didn’t breach 1500 once again until a decade later.
Adjust the numbers according to basic market math, and they’re at least as scary as those the JP Morgan bear advanced
Let’s say that the market PE trends downward from its current level of nearly 29, to 22, still elevated by historical standards. That shift would lower the index 25% from where it stands now, about the correction Kolanovic predicted. Or, it’s highly possible that EPS will trend downwards and settle at the $155, adjusted for inflation, that looks justifiable from the Shiller data. It already appears that the gigantic profits booked in the post-COVID recovery aren’t durable; the 500’s EPS has gone flat, and dropped in real terms, since Q4 of 2021. If profits drop to the $150-160 range, after accounting for inflation, even at a big PE of 27, the S&P’s 25% too pricey at its record of 5567 at the close on July 5th.
Keep mind that low interest rates should be great for stocks because they raise the present value of future earnings, and higher real yields are a downer since they reduce what that stream’s worth today. Well, “real yields” have jumped from negative to over 2% while the S&P’s soared. The combination of historically high PEs, probably inflated earnings, and real rates that just went from extremely favorable to normal, aren’t a combination that should breed confidence that stocks will keep climbing. They’re more like the cocktail for a tough hangover.
Once again, the bulls could be right for awhile. But for a much longer period, the science tells us that when you’re starting at these big prices, you’ll get pocket poor returns over the next seven or even five years. A bet for where we’ll be this time next year is no better than a guess. But the more the market booms, the more it sows the seeds of its own demise.
