3 Risks Investors Should Be Watching Now
I’ve recently written about strong, under-appreciated U.S. corporate earnings and a growing “wall of worry”—both of which I’ve argued are bullish for stocks looking ahead. But optimism should be balanced with an acknowledgment of risks that loom in the markets, any of which could derail stocks’ performance in 2024. There are three in particular that I think investors should be watching now.
- Stocks are Fully Valued, Limiting Further Upside
As of May 10th, the forward 12-month P/E ratio for the S&P 500 was 20.4. This means stocks’ valuations are running above 5- and 10-year averages, which are 19.1 and 17.8, respectively. By this metric alone, stocks look fully valued at current levels.
But we also know that in the first quarter, even as inflation measures came in hotter-than-expected and the Fed dashed hopes for rate cuts in 2024, the S&P 500 rallied by 10.6%. Looked at another way, even though investors now expect higher-for-longer interest rates—which reduces the present value of future cash flows—they were still willing to pay a premium for those future earnings.1
Adding to this risk is the observation that enthusiasm over artificial intelligence (AI) has contributed greatly to the recent rise in stock prices. The risk here, of course, is that AI fails to deliver on its promise to drive substantial productivity and profit growth. That would deem many technology companies’ meteoric gains as part of a bubble.
In my view, with valuations at current levels, U.S. corporations have very little room for earnings disappointments. The good news is that earnings were better than expected in Q1, and estimates for Q2 earnings have been increasing since the start of April—which is the opposite of what we tend to see historically. For Q2, S&P 500 earnings are expected to be up +9.2% from the same period last year, which is higher than the 8.7% earnings growth expected at the end of March.
- Election Uncertainty = Higher Volatility
Many investors are already feeling election fatigue, and it is only May.
I will not argue against the idea that uncertainty surrounding the election may result in short-term volatility. I could easily see that being the case. But I also think investors should bear in mind that markets already know both of these candidates, and stocks have already performed well during former President Trump’s term and President Biden’s current term. I’m not suggesting stocks will do well no matter who is elected, but rather that we know from history that stocks can do well.
As an investment manager, I think it’s critical to ‘check political views at the door’ when making decisions. Politics is often filled with emotionally charged views and ideas, neither of which serve investors well and often lead to mistakes. For example, an investor could have avoided stocks during President Trump or President Biden’s tenures for the same reason—because they strongly disliked the leader and his policies. But that would have been a mistake. Stocks have risen substantially over the past eight years, and currently trade near all-time highs.
I think investors have good reason to be optimistic about 2024. Not because of how the election may unfold, but because of how the stock market tends to perform during election years. The last time the stock market fell in a presidential re-election year was 1940.
- The Fed Waits Too Long to Lower Rates
With the benchmark fed funds rate currently in a range of 5.25% to 5.5%, and inflation hovering around 3% to 3.5% (depending on the index cited), monetary policy is restrictive. The economy has been chugging along despite higher rates, but history reminds us that monetary policy works on a lag and deep cracks can start to take shape well before anyone realizes it.
One area of concern, in my view, could be for small- to mid-size businesses. These types of businesses employ about 75% of the private workforce, and they also tend to rely on debt more than cash-rich larger corporations. These companies’ ability to repay interest obligations is below where it was before the pandemic, and having to refinance at higher rates could impact profitability—and result in cost-cutting measures like laying off some of the workforce.
In my view, the risk of delaying rate cuts outweighs the risk of cutting too early and triggering more inflation. It remains to be seen how the Federal Reserve threads this needle. One reason for cautious optimism, however, is that there appears to be some certainty among businesses and investors that interest rates will not move any higher from here—which I think significantly reduces the possibility of a negative surprise.
Bottom Line for Investors
U.S. corporations could disappoint, even just slightly, on earnings. The U.S. presidential election could deliver a surprise twist that amplifies uncertainties beyond Election Day. The Federal Reserve could wait too long to cut rates, placing additional strain on small- and mid-size businesses, banks, and U.S. consumers—ultimately hurting economic activity.
These are all risks investors should keep in mind as the year progresses, while also remembering that better-than-expected outcomes—i.e., positive surprises—could send stocks even higher.
Disclosure
1 J.P. Morgan. May 3, 2024. https://www.jpmorgan.com/insights/outlook/market-outlook/tmt-midnight-musings-3-risks-keeping-us-up-at-night?jp_cmp=pw/ContentSharedViaAdvisorChannel/ema/OFTtemplate05032024&mkt_tok=Mzc3LVJFUS05NTcAAAGS39_HvGDP3uruz1NUYElB05WwDETFCHK8HVpijy-a9AECfMh3ygVvB3k6kZTMUQmIYNv91gpKIneFXrznY1_YGs8h6MGj4EReGBtUvXK8htr7kw
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