Market Highs

Estimated reading time: 5 minutes

The Highs Keep Coming

We find ourselves in interesting times. The S&P 500, the Dow Jones Industrial Average, and the Nasdaq 100 have hit new all-time highs. The Nasdaq Composite is within a whisker of surpassing its previous all-time high from November 2021.

It’s the end of February, and already half of strategists’ year-end S&P price targets have been surpassed. The highest year-end target sits at 5,400 and is only 6.5% above where the index stands today, while the median target is 5,060 and is almost exactly where the index closed on Feb 28th. We’ve already started to see firms move their targets up as the market climbs.

Those are referred to as top-down price targets, but it’s also important — if not more important — to look at the bottom-up estimates. Rather than trying to call a broad index level, bottom-up analysts place price targets on the individual stocks they cover. One could argue that those analysts are more clued into the intricacies of each company and have the opportunity to be more accurate in forecasting future stock movements. For S&P 500 companies, we can aggregate the bottom-up price targets and create a weighted average that gives us a target on the broader index. The chart below shows this aggregated price target on the S&P versus the actual index level to illustrate the “usual” gap between the two.

The aggregated bottom-up target is still 9.2% above where the S&P closed on Feb 28th, and suggests decent upside over the next 12 months. However, we can see that the gap between the target and the index level is narrow compared to history. That’s not necessarily a bad thing, but it does show us that analysts as a group are usually more bullish than they are today.

Fear of Heights

In any event, things seem to be going well on a number of fronts. Market highs keep coming, other sectors besides mega cap tech are performing well, and markets seem relatively nonplussed by the idea that Fed rate cuts are being pushed further and further into the future.

Many investors are naturally skeptical, especially at extremes. There’s also the temptation to be a contrarian and think the thing that seemingly no one else is thinking. The number of market participants who have turned more bullish this year continues to climb, but so does the chatter about whether we’ve gone too far.

Many of the debates center around where people think we are in the business cycle — for example, if we’re mid-cycle, there’s more room for upside, but if we’re late cycle, there’s less room. No one knows where exactly we are, and no one knows if or when it will change.

One investor who undoubtedly knows more than most about market environments and opportunities is the great Warren Buffett. He uses a valuation ratio, coined the “Buffett Indicator”, that compares the market cap of the Wilshire 5000 index to U.S. nominal GDP.

Using this metric, the current level of 1.9 shows us that the market is the most expensive it’s been since April 2022, right around when the Fed started hiking rates. Now the Fed is likely done hiking rates and the market has recovered what it lost and then some. But rates are still the highest they’ve been in 23 years.

That suggests surprising resilience, and something that can’t be ignored. Something else we shouldn’t ignore though is the set of signals such as the Buffett Indicator that are telling us, at the very least, that the market is overvalued.

Just because it looks overvalued broadly, doesn’t mean there aren’t good opportunities. I believe the rotation out of the Magnificent 7 stocks will continue, but investors still have enough risk appetite to stay in equities. And I believe that risk appetite can stay alive unless the labor market becomes a concern (see last week’s column, “Lay Off the Optimism”), or a new shock emerges.

For now, look for spots to rotate into that have flown under the radar this year. Some ideas I’d put on that list are dividend stocks, Utilities, Energy, and Materials. Industrials stocks have had a strong and well-documented rally since last fall, but if the economy muscles through 2024, these companies can continue to do well.

The exception to this story is the Russell 2000, which is still 16% below its all-time high and hasn’t yet shown an ability to get off the mat. Since I think we’re more late-cycle than mid-cycle, I’d skew toward large-cap stocks rather than small-caps. And the behavior of small-caps continues to keep a lid on my optimism, but if they break out for good, that could be the confirmation we need of more sustainable upside.

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