Post-election euphoria dashed by market crash concerns

Investors have undeniably reaped the rewards of their risky choices this year, but as the US continues to enjoy its “post-election euphoria” concerns have arisen as to how much longer current market valuations will hold, according to a leading analyst.

Chris Iggo, AXA Investment Managers’ Chief Investment Officer for its Core division, said the US market could be heading for a market correction, which has historically followed periods of “extreme valuation levels”, such as that seen currently with corporate tax cuts, deregulation and ‘US exceptionalism’ on the horizon.

“There are several things to consider. One is the level of earnings and how they will evolve and particularly how they will grow in real terms.

“A second is the multiple of stock prices to earnings, and a third is the level of risk-free yields. Today, earnings for the S&P 500 universe are expected to grow by 14% over the next 12 months, inflation is projected to be around 2.5% and bond yields are forecast to be largely unchanged. No need for concern then.

“On that basis the market could comfortably reach a level of around 6,500 without valuation metrics materially worsening. So what might it take to create the conditions for a significant market adjustment?

“I [used the methodology developed by the economist Robert Shiller] to estimate the five-year cyclically and inflation adjusted price-earnings (CAIPE5) ratio for the S&P 500. It currently stands at 28.4 times compared to the 12-month forward price-to-earnings ratio (PE) of 22.3 times.

“On my measure, the CAIPE5 has peaked at around 30 times on two previous occasions in the last 34 years – 1999-2000 and in early 2022 on the eve of the most recent Federal Reserve tightening cycle. On both occasions, the market fell, and subsequent equity returns were negative.”

Iggo warned that Donald Trump’s projected policies could lead to market shock, through scenarios of higher inflation and bond yields, as well as an increase in the market index price level, but stopped short of expecting a decline in equities.

“Indeed, our core outlook is still positive on equities, especially US stocks. But I am sure that US stock valuations will remain a core element of discussions amongst finance professionals in 2025. The valuation numbers are clearly distorted by what has happened with technology stocks and there is an even keener focus on the so-called Magnificent 7,” he said.

“The earnings rise for leading technology companies reflects an important technological jump with the advent of artificial intelligence (AI) technologies. There is clearly a belief that AI will lead to productivity growth and a stronger US economy. I believe that too. However, as we saw in 2000, not every technology story works out well. Anything that temporarily, questions the AI theme – regulation, technology failure and/or supply chain shocks – could dramatically impact technology sector valuations.

“I said this in relation to credit spreads recently – expensive valuations themselves don’t guarantee negative returns. However, they change the risk. There still needs to be a trigger, and Trump’s policy agenda, the fragile political-economic situation in Europe and China’s struggles to develop economic stimulus could all potentially spur on a deterioration in investor confidence.

“The S&P 500 has delivered a total return of 35% since the Fed’s last rate hike in July 2023 and looks set to record two consecutive years of more than 25% total return. Given the backdrop, a third might be stretching it. Caution is required.”