The US stock market saw a new all-time high yesterday, with the Dow Industrial, S&P 500, and Nasdaq all confirming the milestone simultaneously. Meanwhile, US inflation once again demonstrated its persistence, making it challenging for the Federal Reserve to consider rate cuts. The prevalence of stock bears in the market has dwindled, as indicated by the Put/Call ratio falling to 0.56. However, pertinent questions arises: are stocks currently overvalued? Is there potential for the current bullish trend to continue? To shed light on these questions, here are some charts that may offer some insight.
(Inflation Adjusted S&P 500 Total Return Index)
Inflation poses a complex dynamic for stocks. When inflation runs high, nominal earnings increase due to higher prices, which in turn can boost stock prices. However, high inflation often accompanies rate hikes and tighter financial conditions, leading to shrinking consumer confidence and hits to profit margins. Despite these challenges, the S&P has demonstrated a resilient track record against inflation throughout history. Since 1988 (the inception of the total return index), the inflation-adjusted S&P 500 Total Return Index has consistently risen. Examining the last five years with regression lines, the S&P’s performance against inflation is above the main regression and close to +1 standard deviation. Despite being slightly elevated, there appears to be sufficient room for further growth.
(S&P 500/Gold Ratio)
The stable performance against inflation is increasingly attracting more traders and investors to the stock market as an inflation hedge. Consequently, the obvious question arises: how does the S&P 500 compare to the classic inflation hedge and safe haven asset, gold, during the coronavirus shock and subsequent high inflation period? As depicted in the chart, the Covid-19 pandemic significantly impacted stocks due to massive disruptions in supply chains. However, after the initial shock, the S&P 500 has navigated the high inflation environment similarly to gold. The stocks-to-gold ratio has remained almost flat over the last three years and is currently very close to the five-year average.
(S&P 500/Gold Ratio)
Another challenge during periods of high inflation is the accompanying high interest rates. Increased rates lead to tightened financial conditions and a slowdown in the economy, which can have a negative impact on the stock market. However, in the current rate hike cycle, it appears that the neutral rate has also increased. Despite the Federal Reserve rate being at 5.5%, the Bloomberg Financial Conditions Index is as high as it was in 2021 when the rate was only 0.25%. High inflation combined with loose financial conditions creates an optimal environment for the stock market to thrive.
(5-Year P/E Ratio Average and Deviations)
In terms of valuations, the S&P 500 is currently priced at a price-to-earnings ratio of 25.4x, which is higher than the five-year average of 22.6x. However, during bull runs, the index often reaches much higher valuations. If the ratio were to reach +1 standard deviation, indicating a 4.33% increase, it could surpass 5500, which is not a small possibility.
(Percentage of S&P 500 Members with 30< and >70 RSI)
From a more technical standpoint, the number of S&P 500 members with RSI levels over 70 is increasing alongside the new highs. However, there still appears to be ample room for further growth. In previous market peaks, this percentage reached much higher levels before momentum began to wane.
(VIX Index)
The VIX is one of the best tools to gauge market sentiment. Over the last three years, the average VIX stood at 19.79. However, over the past year, this average dropped to 14.71, and since the beginning of 2024, it has further decreased to 14.22, despite the sudden surge in April. A consistently low average, coupled with lower highs in the VIX, suggests that traders anticipate the S&P 500’s upward trajectory to persist for the foreseeable future.
(E-Mini S&P 500 Daily Chart)
The index reached a new high yesterday and is approaching the upper line of the trend channel. As the above indicators demonstrate, the S&P 500 is certainly not cheap at the moment. However, if the current conditions persist, it still has some potential for further gains. Approaching the 5500 mark, some traders may start profit-taking, potentially slowing momentum. Yet, with rate cuts on the horizon, upward pressure could persist throughout 2024. Fibonacci extension 76.4% alongside with the upper line are some of the possible targets for the short term.
