U.S. Stock Market Pauses as Valuations Reach 22.9 Times Earnings

After a period of rapid gains, the U.S. stock market has shown signs of fatigue, with investors becoming hesitant as they weigh high valuations against potential macroeconomic risks. On Wednesday, the three major U.S. stock indices continued their decline, with the Dow Jones Industrial Average erasing all gains made since the Federal Reserve's meeting. Strategists on Wall Street believe the market has entered a "pause period," actively seeking new catalysts to drive further gains.

Data from a major U.S. bank indicates that based on 19 out of 20 indicators, the U.S. stock market is currently trading at an expensive level. The forward price-to-earnings ratio for the S&P 500 index reached a high of 22.9 times this week, a level that has only been surpassed twice in this century: during the dot-com bubble burst and the summer of 2020 when the Federal Reserve cut interest rates to near zero in response to the pandemic.

However, some of the most optimistic voices on Wall Street believe that any pullback will be short-lived. One strategist even suggested that the most likely factor to disrupt the current bull market would be "a small asteroid hitting Earth." Another strategist predicted that continued weakness in the U.S. labor market would prompt the Federal Reserve to further cut interest rates, with reductions of 25 basis points expected at each meeting until January 2026. In this scenario, the S&P 500 index is projected to trade around 6800 points by June 2026.

Strategists on Wall Street generally agree that the market may experience a period of consolidation in the short term. One strategist described the current situation as a "timeout," noting that while the strong upward trend has not yet ended, the potential for further gains is diminishing as stock prices continue to rise. This view is supported by another strategist, who cautioned that the frenzy surrounding artificial intelligence has led some skeptics to buy stocks at high prices, increasing the market's downside risk.

The S&P 500 index has rebounded nearly 35% since its low in April, continuing to rise during the traditionally weak seasonal period. This has fueled concerns about a potential bubble, particularly in the technology sector. The forward price-to-earnings ratio for the S&P 500 index reached a high of 22.9 times this week, a level that has only been surpassed twice in this century: during the dot-com bubble burst and the summer of 2020 when the Federal Reserve cut interest rates to near zero in response to the pandemic.

While high valuations are a key factor driving market concerns, there are differing opinions on whether they are justified. One strategist suggested that given the increased visibility and predictability of corporate earnings, the current high price-to-earnings ratio for the S&P 500 index may be reasonable. They argued that investors are willing to pay a premium for predictable assets, and that the market should view the current valuation levels as a "new normal" rather than expecting a return to historical averages.

In addition to valuation concerns, some macroeconomic risks are beginning to emerge. Issues such as sticky inflation and a slowing expansion in the labor market could pose obstacles for the market. One strategist noted that inflation concerns resurface every few months, making the key price data due on Friday crucial in either alleviating or exacerbating these concerns.

However, from a historical and positioning perspective, bulls still have reasons to be optimistic. One strategist pointed out that while the market's continued rise is fueling "bubble" talk, there are sufficient reasons to believe that this narrative is incorrect. Over the past 50 years, there have been five bull markets that lasted more than two years, with an average duration of eight years. The current bull market, which began in October 2022, is not yet three years old.

Another strategist also noted that sentiment and positioning indicators suggest that the current rally is based on "cautious optimism" rather than speculative excess. They believe that this sentiment and positioning backdrop supports a constructive outlook for the stock market. One strategist also found comfort in historical data, pointing out that since World War II, there has never been a second decline of more than 10% in the same year following an opening-year decline of more than 11%. However, they also cautioned investors to prepare for volatility in October, as the standard deviation of monthly returns for that month is 33% higher than the average for the other 11 months.