The S&P 500's impressive year-to-date run has done wonders for investors around the globe as it has recovered from the severe losses suffered in 2022. However, after an unanticipated 18% year-to-date surge, the question becomes: Is the S&P 500 positioned for further growth, or is it overvalued? Let's take an in-depth look at the salient features of today's market environment to see if we can answer this central question.
Economic variables
The primary driver of the stock market is supposedly the economy, or more specifically the flow of money, though of course the stock market often becomes disconnected from the economy due to the more powerful (yet more volatile) force of public opinion. Economic growth can be divided into two segments, namely long-term trend growth and cyclical growth. The latter is probably more important to investors who want to determine whether the S&P 500's year-to-date surge is sustainable.
The "GDPNow" composite is often used to forecast an ex-ante quarter's GDP growth by aggregating the economy's salient influencing variables. Although it is not always accurate, there are some investors who place their bets based on the composite's forecast.
According to the latest GDPNow data, the U.S.'s second-quarter GDP is expected to expand by 2.3% year-over-year, which is definitely respectable; moreover, the composite suggests that consumer sentiment is forecasted to recover sharply alongside fixed capital investments, which is encouraging to see. Altogether, the data suggest that the U.S. economy is looking up compared to its performance in the recent months.
Source: Atlanta Fed
Another critical variable to look at when determining the cyclical trajectory of the economy and the stock market alike is durable goods orders. Demand for durable goods is as cyclical as it gets as consumers tend to drift away from long-life consumer products during periods of uncertainty. In contrast, consumers buy durable goods when they think the economic outlook is bright.
The latest data suggests an abrupt uptick in durable goods orders, implying that consumer sentiment in the U.S. is improving, which leads to the conclusion that the real economy is recovering from its early-year wobbles.
Source: Trading Economics
Lastly, and probably most vital to stocks, CDS values must be considered. CDS values convey the credit risk embedded within the financial markets and often exhibit a negative correlation to risky assets such as corporate bonds and stocks.
As revealed by the latest CDS Values, U.S. credit risk is abating, leading me to conclude that stock valuations could be set to edge higher in the coming quarters.
Source: World Government Bonds
The U.S. economy remains at risk of a cyclical contraction due to elevated interest rates. Nevertheless, the economy's salient features are improving, providing substance to an argument that the S&P 500's year-to-date recovery is sustainable.
S&P 500 valuation
When valuing the S&P 500, I like to use Shiller's CAPE model, which provides a seminal method that considers factors such as real growth, inflation and cyclicality, giving investors a holistic understanding of the index's price level.
The model phase a 10-year inflation-adjusted average earnings per share into a price-earnings model to orchestrate a relative valuation benchmark. According to the CAPE, the S&P 500 is currently overvalued as its price-earnings ratio of 31.1 exceeds the historical average of 17.4.
A birds-eye view implies that Shiller's CAPE suggests the S&P 500 is overvalued because of high inflation during the past year, which drove nominal corporate earnings higher but depleted real earnings. Moreover, the S&P 500's modern composition is growth-stock-centric as opposed to its past composition, which was more blended; as such, the CAPE displays risks of diminishing real growth and index concentration.
Technical analysis
The S&P 500 Trust ETF (SPY, Financial) is an S&P 500 tracking fund that provides valuable indicators about the index. One such indication is the index's technical position.
The S&P 500 is trading above its 5-, 50-, 100- and 200-day moving averages, suggesting that market participants have invested with amplitude since the turn of the year.
Even though momentum investing can be a profitable strategy to implement, crash risk always remains of concern, and the S&P 500 Trust ETF's relative strength index (RSI) figure of 63 conveys just that. As a rule of thumb, an RSI that nears or exceeds 70 is a red flag, suggesting that the underlying asset is overbought. As such, investors would be wise to consider retracement risk.
Final word
Although macroeconomic variables and market risk premiums imply further upside potential for the S&P 500, seminal valuation metrics and a parsimonious technical analysis contradict the notion. Thus, I believe that the S&P 500's trajectory is indeterminate for now and investors would be wise to play a waiting game for the time being.
