The Pitfalls of Over Optimism

Sometimes headlines drive me a little crazy. This week I read, “UBS sees S&P 500 soaring to 6400 by the end of 2025.”

Soaring? Really? When that headline came across the ticker, the S&P was trading just a smidge above 5840. I double checked my math and 6400 is slightly less than a 10% gain over the next five quarters. On October 12, 2022, just two years ago, the S&P 500 index closed at 3577 – we are up right now at 60% since then. Now that’s soaring!

The UBS forecast does bring me to something more productive than media criticism, though. To me, 6400 sounds about right. Most years my prediction is for about a 10% gain, which is always a reasonable guess. For 2025, a target of 6400 represents a dramatic slowing of the growth in the stock market. It’s not a reversal: slower growth is still growth, and 10% over a year and a couple of months is healthy. There is absolutely nothing wrong with getting rich slowly.

Yet there is an insidious danger to the over enthusiastic investor in a slowing growth environment. Too many investors have too short memories and will not be content with a market chugging along at 10% growth. Many investors expect the 30% we have seen over the last two years and are impatient, wanting a SOARING! market – not just a market chugging along. It is too easy to talk oneself into risk by ignoring the hoary disclaimer of “past performance is not an indicator of future results.”

I am surprised by the bull market surge of the last two years. Coming out of the pandemic recovery, signs of recession were all around, most notably the yield curve inversion that began in the summer of 2022. I have always been a huge believer in the resilience of the American economy, and even I was surprised at how the economy shifted, without much grinding of the proverbial gears, from rebound to recovery and then to expansion following the pandemic.

To be clear, I’m thrilled I underestimated the strength of the economy, and the bull market it has engendered.

Markets have surged over the last two years as earnings have expanded, and the promise of AI has pushed companies into new positions of market leadership. At times, the hype has outpaced the fundamentals, but we have avoided systemic bubbles. Perhaps parts of the stock market have become bubbly, but overall valuations haven’t become outrageous.

The chart above shows that the surge of the last two years has seen a meaningful expansion of the forward price-to-earnings multiple. At 22x NTM earnings ,markets are rich, above the average of the last five years but not the highest we’ve seen. Further, as I wrote last week discussing the price-to-earnings growth ratio, because of the strength of earnings growth, the rich valuation can be largely justified.

I don’t see the type of widespread distortions that presaged the massive reversals I’ve seen earlier in my career, such as the dot com bubble or the Great Financial Crisis. The forward multiple valuations of the market moving back to the mean is certainly possible (and keep in mind that corrections are never as simple as reverting to the mean – they shoot through the mean and then return) but with the strength of earnings, a modest gain for 2025 is a reasonable forecast, even if the path there includes a correction.

The broader economy is chugging along, with inflation approaching the Federal Reserve’s 2% target while unemployment remains at a remarkably low level, 4.1% in the latest report. The economy is expanding at a real rate somewhere above 2%, with the latest GDPNow forecast from the Atlanta Fed predicting a 3.2% increase for the third quarter. There are industries and regions that lag, and even on my most optimistic days, I won’t argue that it is all sunshine and rainbows. I have deep concerns about the longer run of the economy if we do not address our fiscal profligacy that has led us to unprecedented levels of federal government debt, now approaching $36 trillion. Yet, for any and all faults in the current economy and challenges to our future, there is no indication of imminent doom.

Perhaps I shouldn’t be so hard on my editor friends who write headlines. Perhaps “soaring to 6400” is exactly the message we need. Everyone wants the markets to soar, but realistically growth inevitably wanes – and that is healthy because parabolic growth inevitably leads to parabolic collapse. Market bubbles are not healthy, and they are terrifying and painful when they burst.

If we talk ourselves into an 8-10% year being “soaring” perhaps market participants, collectively, won’t venture too far out on the risk profile.

At Farr, Miller & Washington, we scrupulously hold to our dictum that emotion is the foe of the long-term investor. We avoid the exuberance of “soaring” as well as the despair of “crashing” and all of the other emotive descriptors of the headline writers. We dig beyond the top lines of earnings reports in our research to discover long-term value and expose underlying risk, and we take a dispassionate view of the course best for our clients.

Whether the market soars, stalls, slips, shimmies or whatever other colorful language comes from the press, our dedication to our clients’ interests never waivers.