What could possibly go wrong?

Let’s face it – the stock market is having a great year. Despite considerable doom and gloom as we began 2023, the S&P 500 is up more than 18% year to date, recovering much, but not all of 2022’s loss. For the record, the S&P 500 began 2022 at 4766, about 5% higher than Friday’s close. As we move into the second half of the year, sentiment has now shifted to the positive and it is worth considering what could possibly go wrong. Here is our current worry list:

1. A resurgence of inflation

Yes, inflation is falling and that is one of the primary drivers behind this year’s rally. However, inflation is not yet defeated, and a resurgence of inflation would be a significant negative for the market. The worry is that the economy is still too hot and could still produce rising prices. 3rd quarter GDP is estimated at 3.9% according to the Atlanta Fed’s GDPNow forecast and housing prices are still elevated, and the job market is still tight. If the strong economy continues to drive up wages, we could see a ‘feedback loop’ where higher wages result in higher demand which results in higher prices.

2. Bullish sentiment

We began 2023 with very negative sentiment with many economists, including Jamie Dimon of JP Morgan, forecasting an impending ‘economic hurricane’. So far, no such storm has come, and economists are increasingly forecasting no significant recession. The result has been a significant shift in investor attitude from negative to positive. The worry is that investors have become too positive. One measure of investor attitude is the Investor Intelligence Bull/Bear ratio, which surveys investor’s market expectations. If investors expect the market to rise in the coming months they are in the “bull” camp, and if investors expect the market to fall in the coming months they are in the “bear” camp. The ratio of bulls to bears is an indicator of investor sentiment. Sentiment is a contrarian indicator, meaning that when investors are overly positive, it is usually an indicator that we are nearing a market top. As of 8/1 the Bull/Bear ratio was 3.07, reaching a threshold usually considered extremely positive.

3. High Valuations

We began 2023 with cheap valuations but as investor sentiment has improved stocks have become more expensive. The worry is that stock prices are expensive, already pricing-in the good news of the economy and are ripe of a negative economic surprise. The S&P 500 forward Price Earnings Ratio, an indicator of stock valuation was at 19.6 as of 7/28, relatively high compared to the 5-year average of 18.6 and 10-year average of 16.7.

4. Geopolitics

There is of course a war going on, and while the market has shrugged off the conflict, the worry is that the conflict will spill over to other regions. Moreover, there is increasing tension between the US and China and Israel and Iran. We are also entering a contentious presidential election season here in the US. It all adds up to a worry that there could be a destabilizing event on the political front.

Conclusion

They say that bull markets ‘climbs a wall of worry’ and this year’s market has been no exception. We said from the beginning of the year that risks are high, and we still believe that. It does not mean that we predict a collapse in the market, but we do want to remember that risks are still out there. It is always important to consider what could go wrong and be appropriately defensive.