Sometimes dreams can come true.
The
S&P 500
‘s recent run higher has raised hope that the index can reach its record closing high of 4796.56 by the end of the year, making up all the ground it lost in 2022. Some people on Wall Street are calling for a correction, but reaching the high-water mark remains a possibility.
There is no doubt that at its current level near 4570, the index looks expensive. The S&P 500 is now trading at just over 19 times the aggregate earnings per share its component companies are expected to produce over the next year, up from about 15 times at the start of the index’s 27% rally from its low point in October.
That is a particularly high multiple, given where interest rates are, because higher rates reduce the current discounted value of future profits. The fact that the market is pricey makes it vulnerable to a drop if anything goes wrong.
And yet the same logic that has driven the market rally to date could drive the next leg of gains. The market has taken declines in the rate of inflation as a sign that the Federal Reserve will soon stop raising interest rates to rein in price growth by limiting demand for goods and services. If investors are right, the damage from higher rates will dissipate, allowing earnings to grow.
And profits could rise in any case for Big Tech, some of the market’s most significant companies, given the rise of artificial intelligence. Some analysts have raised their profit estimates in response, assuming growth in earnings for years to come.
At the same time, rates could drop. The two-year Treasury yield, which reflects expectations about the federal-funds rate, is just under 4.8%. That leaves it a bit short of 5%, the highest in more than a decade, and not likely to go much higher. It could fall if investors start to price in the possibility of rate cuts, something that would also drag down the 10-year yield, now at about 3.75%.
Expectations for average annual inflation over the next decade are at about 2.2%, according to data from the St. Louis Fed, so investors holding that debt are amply compensated for inflation. Any buying of the bond could send its price up and the yield down.
If the 10-year yield falls to, say, 3%, that could mean the S&P 500 can trade at a multiple in the mid-to-high teens. The last time the 10-year yield was that low, in late August, the S&P 500 traded at just under 18 times forward EPS. That multiple is a little below the current level, but it could be enough to keep the index moving higher.
That is because lower interest rates would help the economy—and corporate profits—to grow. Lower Treasury yields could drag down rates on all sorts of debt, such as mortgages, auto loans, credit cards, and corporate bonds. That means people could spend more and companies could borrow and invest more, boosting economic activity.
That could enable earnings to come in higher than expected. Currently, analysts for S&P 500 companies are expecting an aggregate EPS result in 2024 of about $244, according to FactSet. But companies that had reported their results as of Tuesday morning had beaten second- quarter estimates by about 8%, according to Evercore data.
If profits were expected to be that much higher next year, it would bring forecast aggregate EPS to about $263.50. In that case, a multiple of 18.2 times for the index would bring it to its record high.
All that seems highly optimistic, but there is reason to the rhyme. Even if earnings forecasts don’t rise quite to that level, the market would get excited that the direction for profits is upward. Momentum could take over, sending the earnings multiple even higher.
Societe Générale’s
momentum indicator “suggests equity momentum mania to build further,” wrote the bank’s strategists.
They see the S&P 500 hitting 4750 this year. If rates and earnings move in the right direction, the sky could be the limit.
Write to Jacob Sonenshine at [email protected]
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