What happened
Since the mid-June lows, the technology-heavy NASDAQ Composite has climbed more than 20%, and the S&P 500 is up about 15%. So, the question becomes, now what?
Our take
After the sharp rebound and as the S&P 500 climbs closer to the upper end of our estimated range, the market’s risk/reward appears less favorable. Given an ongoing slowdown in the economy and earnings risk, our view remains that the S&P 500’s near-term upside potential is likely capped in roughly the 4200-4300 range, or 2% to 4% upside from current levels (note – the S&P 500 traded to 4186 on Monday). We believe the near-term downside potential exceeds this upside potential.
The top side of our estimated range coincides with a confluence of technical price and valuation levels. The S&P 500’s price high in May was around the 4300 level, and the downward sloping 200-day moving average is currently nearby at 4333. Likewise, we see fundamental resistance for the S&P 500 around a 17.5x to 18.0x forward P/E, which roughly coincides with the aforementioned price range.
Indeed, the S&P 500’s forward P/E has already expanded from a low of 15.3x at the June low to 17.5x. The entire rally witnessed since mid-June has been driven by valuation expansion. This increase was partly based on hope of a Federal Reserve (Fed) pivot to a less aggressive policy stance and a sharp pullback in the 10-year U.S. Treasury yield. Such a pivot seems less likely near term given the very strong employment report from last week.
Notably, outside of the pandemic, which saw an overshoot of valuations given massive stimulus and very low interest rates, the S&P 500 has been unable to sustain a P/E above 18x for a prolonged period.
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