Warning equity markets 'priced for perfection'

Have equity markets peaked?

Tom Eckett

Bear market

Overexuberance has been a key theme of 2024 as fund selectors attempt to navigate a market environment that is “priced for perfection”.

Off the back of a stronger-than-expected year for risk assets in 2023, markets have continued to soar, driven by strong earnings from the ‘magnificent seven’ stocks amid the craze in AI.

Nvidia, for example, recently posted revenues of $22.1bn in Q4 2023, $1.7bn ahead of expectations, with Q2 revenues forecasted to climb to $24bn,

As a result, the S&P 500 is up almost 10% so far this year, as at 13 March, as investors position for a perfect landing that will see the US economy avoid a deep recession, a boon for risk assets.

However, with valuations stretched, geopolitical risks abound, the higher-for-longer inflation narrative in play and investor optimism at high levels, there are reasons for fund selectors to be cautious.

“The risk-reward is negatively skewed,” Marko Kolanovic, chief market strategist and co-head of global research at JP Morgan, warned. “Markets are priced for perfection as valuations are rich and extreme crowding in momentum stocks risks a sharp correction in this factor.

“Markets are ignoring the substantial geopolitical and political risks given their apparent lack of immediacy, and that inflation risks are skewed to the upside, which could keep central banks’ target rates higher for longer.”

Stronger-than-expected US jobs data also saw payrolls increase by 275,000 in February, ahead of 200,000 forecasts, combined with US inflation jumping 3.2% last month has created a headache for the Federal Reserve.

As a result, Kolanovic said JP Morgan is defensively positioned across its model portfolios – underweight in equities and overweight in cash and commodities – given the risk of inflation forcing the Fed to keep interest rates at more elevated levels than market expectations.

View from the buyside

Echoing his views, Ernst Knacke, head of research at Shard Capital, said the current market environment means investors have “no margin of safety”.

“It all comes down to liquidity dynamics over the next few weeks and months and perhaps the performance of a handful of large technology companies in the US,” Knacke told ETF Stream.

“From a risk-reward perspective, an overweight in equities is unjustified, at least not from a market cap perspective.”

Adopting an equal-weight approach to US equities has been one of the plays for fund selectors following the sharp rally in ‘magnificent seven’ stocks over the past 12 months. Highlighting this, the Xtrackers S&P 500 Equal Weight UCITS ETF (XDEW) captured over $2bn inflows in 2023 alone.

However, Nathan Sweeney, CIO of multi-asset at Marlborough, is more bullish on his assessment of markets.

“Equity market highs are often greeted with scepticism,” Sweeney told ETF Stream. “The irony is that markets are always moving higher over time, generally due to technological advances that lead to productivity growth.

“Today, advances in AI and automation are driving a very real ramp-up in productivity growth, which means we are likely to reach multiple higher highs for a sustained period.”

Final word

Overall, the S&P 500’s performance is inextricably linked to Nvidia as the AI euphoria drives stock market returns.

If this reverses, investors could face a more challenging environment, especially if the US economy and inflation are more stubborn than expectations. Fund selectors will need to tread carefully in the months ahead.