S&P 500 Is 20% Overvalued — Watch For These Warning Signs: Analyst

Following a 27% run this year, the S&P 500 is concerningly 20% overvalued, says a prominent chief investment officer. And wise investors should keep an eye out for early warning signs of trouble.

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It’s a paradox, though. The S&P 500 seems to only know one direction: Up. But the market’s valuation continues to push into nosebleed heights. Big cap stocks are up 60% this year, while earnings rose just 16%, says Jack Ablin, CIO at Cresset Asset Management.

“How should investors approach a market in which valuation says ‘sell’ but momentum says ‘buy?'” Ablin said. “Traditional valuation measures suggest the S&P 500 is currently more than 20% overvalued, yet trend-following measures, like momentum, remain strong.”

Why The S&P 500 Looks Overvalued

Savvy investors compare the valuations of comparable assets for signs of bubbles. And doing so points to a richly valued S&P 500.

Ablin found the S&P 500’s earning yield, which is its expected earnings divided by its price, is less than the yield of intermediate-maturity corporate bonds. The S&P 500 should trade for 20-times earnings based on this measure. But in reality it’s trading for 25 times earnings, Ablin found.

But here’s the rub. Pricey markets can — and often do — rise further still. That’s why it’s important for investors to have other ways of spotting overvaluation.

What Will Be The Tip Offs Of Trouble?

A fade in momentum would be a sign reality is catching up to the S&P 500. When the S&P 500’s 50-day moving average slips below the 200-day, “momentum is negative,” Ablin said.

“Momentum has been a useful directional S&P 500 trading tool,” Ablin said. “The momentum indicator issued a sell signal in March 2022 and a subsequent buy signal in February 2023, helping avoid 11% of 2022’s 18% downturn, yet allowing investors to capitalize on the 2023-2024 rally.”

It’s also wise to monitor any loss of support for high-momentum stocks. The Invesco S&P 500 Momentum ETF (SPMO) is up 49.3% this year, says Morningstar Direct. That makes it the top-performing actively traded U.S. diversified ETF. And the biggest holdings are Amazon.com (AMZN), Nvidia (NVDA) and Meta Platforms (META), up 50%, 178% and 78%, respectively. If those stocks fade, that could be a sign of flagging momentum.

More Warning Signs

Nicholas Colas of Datatrek Research says three “usual suspects” and five less common triggers could turn markets bearish.

The usual suspects would be a geopolitical shock that pushes oil prices up, a halt in Fed rate cuts and worries about global growth.

And the less-likely problems would be an Enron-like corporate fraud, a blow-up with a key founder like Tesla‘s (TSLA) Elon Musk, a crash in crypto, global weakness due to a strong dollar or a further melt-up by stocks, Colas says.

Who knows if any of these events will happen. But S&P 500 investors are wise to weigh their options.

“With the 10-year S&P 500 expected return at around 5%, there are better alternatives,” Ablin said. “The 10-year, BBB corporate bond, for example, offers investors a 5% annualized return if held to maturity — with meaningfully lower volatility.”

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Largest positions in Invesco S&P 500 Momentum