Stock market rally looks ‘unsustainable’ as S&P 500 introduces ‘new lower valuation regime’, warns Citi

This year’s stock market rally has pushed the S&P 500 index to valuation levels that make it difficult for the index to rise much higher based on the current macroeconomic environment, according to Citigroup Inc.

The S&P 500’s lagging price-to-earnings ratio is back to 18.2x, “perilously close to the high end of our fair value range,” Citi analysts said in a Jan. 13 research report. S&P 500 trading range call for now.”

U.S. stocks are up year-to-date this month, with the S&P 500 up 4.2% through Friday, when investors entered a three-day weekend in honor of Martin Luther King Jr.
traded 0.1% lower at around 3,994 at last check, according to data from FactSet.

“For now, we suspect that valuation may limit the upside momentum in the near term,” the Citi analysts said. “Based on our fair value framework, valuations well above current levels are unsustainable unless there is a significant change in the macroeconomic backdrop.”

According to Citi, the S&P 500 is entering “a new, lower valuation regime” compared to the period since the 2008 global financial crisis.

“This implies that index gains should be ‘earned’ in this new environment relative to short- and medium-term fundamental improvements, and less from macro tailwinds behind multiple reassessments caused by lower interest rates,” the analysts wrote. .

Citi’s fair value framework, according to the report, implies an S&P 500 P/E ratio of 18.5x at the upside based on current rates and other “macro inputs” such as inflation and growth.

“18-19x pushes real value boundaries unless we get a more aggressive slowdown in inflation, noticeably lower rates, coupled with other more optimistic macro readings,” the analysts said.

The chart below shows the range of Citi’s fair value for the S&P 500 versus the index’s underlying P/E ratios since 2021.


Referring to recent customer conversations, Citi analysts said there is “very little conviction that interest rates are on the verge of falling much further below current levels.” That is “in line with the view that the Fed is unlikely to move from hawkish to dovish in a shorter period of time.”

The Federal Reserve has quickly raised rates to combat high inflation, and many investors expect the Fed to potentially pause its rate hikes this year as the high cost of living in the US shows signs of easing.

When interest rates rose last year, the S&P 500 fell 19.4% in its worst performance since 2008.

“We remain confident in our continued view that interest rate-driven valuation headwinds may persist, implying greater importance to earnings trajectories,” the Citi analysts said.

“Sell-side consensus seems to be merging around a weak story in the first half and a strong story in the second half,” they wrote. “We’re more constructive about the second half like many of our peers, but we’re not seeing the same downward pressure on earnings and upside from valuations that others expect.”

The analysts said “this could hamper upward momentum” based on their expectation that S&P 500 earnings per share will fall this year.

U.S. stocks saw mixed trading Tuesday afternoon as investors reviewed Goldman Sachs Group Inc’s fourth-quarter earnings results.
and Morgan Stanley. Morgan Stanley M.S.,
which beat earnings expectations, outperformed the S&P 500 Tuesday afternoon with gains of more than 7%, according to data from FactSet, at last audit.

Read: Goldman Sachs misses its earnings estimate, while Morgan Stanley fares better when earnings fall

As for other major benchmarks in the US stock market, the tech-intensive Nasdaq Composite COMP,
rose 0.1% in Tuesday afternoon trading as the Dow Jones Industrial Average DJIA,
fell 1.1%, according to data from FactSet, at last check.

“We estimate that 28% of the current S&P 500 value is based on future earnings growth, which is in line with longer-term averages,” the Citi analysts said. “We suspect earnings will be more resilient than feared.”

While Citi’s year-end target of 4,000 for the S&P 500 is below the strategist’s average expectation, it estimates the index will see earnings per share of $216 “above those of peer companies,” they wrote. “In other words, we expect a market multiple closer to 18x by the end of the year, versus others around 20x.”

Read: Small-cap stocks are doing better so far in 2023 as US stocks post second week gains this year

Also see: ‘A year with two halves’: Stifel’s Barry Bannister expects a near-term rally in US equities – and trouble later in 2023