Stocks are soaring, but risks abound

With stocks trading well above valuations seen by old-timers, a serious correction may loom on the horizon. The market’s aura of greed could easily turn to fear.

To be sure, it should be noted from the outset that many experts, including some top Wall Street strategists, think equities will just keep rolling merrily along. The S&P 500 has surged more than 2 ½ times from its March 2020 low, and a plunge is no sure thing.

If history is any guide, valuation numbers signal concern. As of Nov. 8, the S&P 500 traded at 22.2 times analysts’ earnings estimates for the next 12 months. That easily exceeds the five-year average of 19.6 and the 10-year average of 18.1.

The cyclically adjusted price-earnings ratio, popularized by Nobel laureate economist Robert Shiller, is even more dire. It calculates earnings based on average profits for the past 10 years and stands at its highest level since the dot-com stock crash of 2000.

When valuations move out of whack to historical averages, they generally return — what’s known as a reversion to mean.

History of stock descents

To give some context, have a look at past stock crashes and what caused them. The S&P 500 tumbled 30% on Oct. 19, 1987. 

There doesn’t seem to be a dominant trigger for the move. Rising interest rates may have played a role as well as the advent of computerized trading. And it could have been a reversion to mean after the market’s jump over the previous five years.

Stocks dropped three straight years from 2000 to 2002, as the dot-com bubble burst. Investors had become overly enthusiastic about the Internet’s growth, pegging unrealistic valuations to virtually any company with dot-com at the end of its name. Many of these companies had no earnings. The Sept. 11, 2001 terrorist attacks also depressed stocks.

In 2008, the S&P 500 plummeted 37% amid the Great Financial Crisis. And the market tanked 34% from late February to late March in 2020, thanks to the onset of the Covid pandemic.

So there are many catalysts that can cause an overvalued market to stumble. Perhaps the biggest threat now is inflation. The Federal Reserve’s 2022-23 tightening program (525 basis points of interest-rate hikes) has pushed inflation down to 2.1%. That almost matches the Fed’s target of 2%.

But now the Fed has dropped rates by 75 basis points starting in September. Meanwhile, incoming President Donald Trump has promised a multitude of spending programs, tariffs and tax cuts that could spark a major bout of price increases.

Concern about the soaring budget deficit also could jolt stocks, although Trump has vowed to slash it. 

The deficit widened to $1.83 trillion in the 12 months through September, representing 6.4% of GDP and up from $1.69 trillion a year earlier. The federal government’s debt has ballooned to $36 trillion.

Again, it should be stressed that there’s no guarantee of a big drop coming for stocks. But the risks are out there. Stocks are now priced for perfection. So if one thing goes wrong, a selling mentality could quickly spread.