Inflation Cools, But Is the Stock Market Still Overvalued?
The stock market has been on fire in 2024, with the S&P 500 surging 16% year-to-date and notching 38 record highs. While this rally has delighted investors, analysts are split on whether the market’s upward momentum will persist or if a correction is on the horizon.
Inflation, Jobs, and the Fed: What’s Next?
On the bullish side, key economic indicators are showing signs of cooling down. Inflation is easing, with consumer prices rising just 2.9% over the 12 months through July, marking the smallest increase since March 2021. At the same time, job growth is slowing, with non-farm payrolls increasing by only 114,000 in July, down significantly from the 215,000 average of the previous 12 months.
These factors have fueled expectations that the Federal Reserve may soon begin cutting interest rates, potentially as early as this month. A rate cut could act as a stimulant for the economy by lowering borrowing costs, thereby supporting corporate earnings growth and, in turn, equity valuations.
Earnings Growth: A Silver Lining?
On the earnings front, the picture remains strong. FactSet’s blended measure of second-quarter earnings growth, which combines actual results from companies that have already reported with estimates for those that have not, shows growth of 10.9% as of August 16. If this holds, it will be the strongest quarterly performance since Q4 2021.
This earnings strength has provided a solid backbone for the market. Analysts are forecasting another robust earnings increase of 5.2% for the third quarter, which could provide further fuel for the bulls.
However, valuations are flashing caution signals. As of August 16, the forward price-to-earnings (P/E) ratio for the S&P 500 stood at 21, significantly higher than the five-year average of 19.4 and the ten-year average of 17.9. These elevated valuations raise questions about whether current prices are justified, especially if earnings growth slows or macroeconomic conditions worsen.
The AI Hype: Fading or Just Pausing?
Another concern for market bears is the recent cooling of the artificial intelligence frenzy that drove a massive rally in mega-cap technology stocks earlier this year. Nvidia (NVDA), often seen as a bellwether for AI, has seen its stock dip by 1% over the past three months. Meanwhile, the S&P 500 itself dropped by 2% on September 3, suggesting that the broader market may be starting to take a breather.
Morgan Stanley’s Take: Jobs Report Holds the Key
According to Michael Wilson, Chief U.S. Equity Strategist at Morgan Stanley, the market’s next move could hinge on the August jobs report due this Friday. “A stronger-than-expected payroll number and lower unemployment rate would likely provide markets with greater confidence that risks to economic growth have subsided,” Wilson wrote in a recent commentary.
Wilson suggests that such an outcome could keep equity valuations elevated and possibly spur gains in other sectors that have lagged behind this year. The bulk of the market’s advance so far has been concentrated in big tech names like Alphabet (GOOGL), Amazon (AMZN), Apple (AAPL), Microsoft (MSFT), and Nvidia.
Morgan Stanley’s economists are forecasting a stronger-than-expected payroll increase of 185,000 for August, which would represent a 62% jump from July’s disappointing figures. They also predict a slight dip in the unemployment rate to 4.2% from 4.3% in July.
However, Wilson warns that another weak report, similar to July’s, coupled with a further rise in the unemployment rate, could reignite concerns about slowing economic growth and put downward pressure on equity valuations. In the previous month, the S&P 500 slipped 8.5% between July 16 and August 5 amid such fears.
Key Takeaways for Traders
For traders, the next big catalyst is clear: Friday’s jobs report. A strong number could signal that the economy is resilient enough to support current stock valuations, while a weak figure could rekindle fears of an economic slowdown and potentially trigger a market correction. With the S&P 500 trading above historical valuation averages and recent volatility in AI stocks like Nvidia, caution may be warranted.
Conclusion
While the market’s impressive run this year has been supported by cooling inflation, slowing job growth, and robust corporate earnings, risks remain on the horizon. Elevated valuations and potential over-reliance on mega-cap tech stocks could spell trouble if economic data disappoints. Traders should keep a close eye on the upcoming jobs report, as it could set the tone for the remainder of the year.
