The S&P 500 index’s recent surge has sparked hope that it can reach its record closing high of 4796.56 by the end of the year, recouping all its losses from 2022. While some Wall Street experts predict a correction, reaching this high-water mark still remains a possibility.
Currently trading near 4570, there’s no denying that the index looks expensive. The S&P 500 now boasts a price-to-earnings ratio of over 19, representing the aggregate earnings per share expected from its component companies over the next year. This multiple has risen from about 15 since the index’s remarkable 27% rally beginning in October.
This elevated multiple raises concerns, especially considering current interest rates. Typically, higher rates reduce the present value of future profits, making the market susceptible to a downturn should anything go awry.
Nevertheless, the same reasoning that propelled the market upward thus far could be the catalyst for future gains. The market has interpreted slower inflation rates as an indication that the Federal Reserve may halt its interest rate hikes designed to curb rising prices. If investors’ predictions prove accurate, the negative impact of higher rates would fade away, fostering earnings growth.
Additionally, Big Tech companies, which wield significant influence in the market, could witness profit increases owing to advancements in artificial intelligence. Some analysts have revised their profit estimates upward, anticipating sustained earnings growth in the years to come.
Moreover, there is potential for rates to decrease. The two-year Treasury yield, which reflects expectations about the federal funds rate, currently stands just below 4.8%. Although this falls short of the highest level in over a decade at 5%, further substantial increases seem unlikely. If investors begin factoring in the possibility of interest rate cuts, this could drive down the 10-year yield, presently hovering around 3.75%.
In conclusion, while the S&P 500’s lofty valuation raises concerns, there remains optimism that it can reach new heights. The market’s interpretation of lower inflation rates and the potential for advancements in technology are among the driving factors. Furthermore, the possibility of rate cuts may further fuel market growth.
Outlook for Inflation and Bond Market
The average annual inflation expectation over the next decade stands at approximately 2.2%, as reported by the St. Louis Fed. Consequently, investors holding government bonds are adequately compensated for inflation. In fact, any surge in bond purchases would drive up bond prices and lower yields.
Implications for Stock Market
If the 10-year bond yield were to decrease to 3%, it could potentially lead to a higher valuation multiple for the S&P 500. In a scenario where the 10-year yield matches this low level, similar to late August figures, the S&P 500 traded at just under 18 times forward EPS. Although slightly lower than the current multiple, this valuation could still push the index towards upward momentum.
Boosting Economic Growth
A decrease in interest rates would not only benefit the economy but also support corporate profits. Lower Treasury yields have a ripple effect, impacting rates across various forms of debt including mortgages, auto loans, credit cards, and corporate bonds. As a result, individuals would have more spending power while businesses would have increased access to borrowing and investment opportunities. This fortifies economic activity and has the potential to exceed projected earnings.
Based on data from FactSet, S&P 500 analysts currently anticipate an aggregate EPS of around $244 by 2024. However, recent reports from companies show they have surpassed second-quarter estimates by approximately 8%, as highlighted in Evercore’s data. If this trend persists and profits are expected to rise significantly next year, forecasted aggregate EPS could reach about $263.50. Consequently, applying a multiple of 18.2 times for the index could drive it to achieve record highs.
While such projections may appear overly optimistic, there is merit behind them. Even if earnings forecasts do not reach those levels, the market would likely respond positively upon witnessing an upward trajectory in profits. This positive momentum could further amplify the earnings multiple, as suggested by Societe Generale’s strategists who predict the S&P 500 to reach 4750 this year. Therefore, if interest rates and earnings continue to move in the desired direction, it offers substantial potential for stock market growth.