US stock market
The U.S. stock market still has a long way to go before reaching its peak, according to Bank of America Merrill Lynch. | Image: Spencer Platt/Getty Images/AFP
  • For U.S. stocks, overvaluation risks have lingered ever since President Trump won the White House.
  • Analysts at Bank of America Merrill Lynch say the S&P 500 Index could have room to grow another 25% from current levels.
  • Recent actions by the Federal Reserve suggest all is not well in the U.S. economy.

Analysts have been sounding the alarm on the U.S. stock market for several years now, but that hasn’t stopped the major indexes from setting new record highs.

The seemingly never-ending market rally is set to broaden in the near term, with the S&P 500 targeting gains of as much as 25% from here, according to strategists at Bank of America (BoA) Merrill Lynch.

S&P 500 Could Hit 3,850: BoA

Technical strategists at Bank of America Merrill Lynch believe the S&P 500 Index could rise as much as 25% to reach 3,850 in the not-too-distant future. From a charting point of view, stocks would need to stage the same type of rally after their last two major downturns in 2015-16 and 2011-12 for such a move to become feasible.

S&P 500 Index YTD
The S&P 500 Index briefly surpassed 3,100 on Tuesday for the first time in history. The large-cap index has returned more than 23% year-to-date. | Chart: Yahoo Finance

Although past performance doesn’t guarantee future success, markets do move in cycles. If the market is currently in a “cyclical consolidation,” as the analysts believe, then a breakout is likely on the horizon.

“History suggests that breakouts from these ranges should be powerful,” the strategists wrote in a note to clients, citing the 3,063 level for the S&P 500.

They added:

Last’ week’s push above SPX 3,063 is an uncomfortable breakout for many who viewed the SPX pattern as bearish.

Stocks have demonstrated breakout potential this month, with the S&P 500, Dow Jones and Nasdaq all hitting record highs. The major catalyst for the rally – an apparent interim trade deal between China and the U.S. – likely won’t be enough to propel equities to the same valuation cited by BoA researchers. With corporate profits and economic growth in a downward spiral, dependence on the Federal Reserve and investors’ never-ending search for yield will likely be the factors that drive the market forward.

Overvaluation is a Legitimate Concern

Whether it’s the price-to-earnings ratio, Robert Shiller’s CAPE index or the extreme separation between economic health and stock-market returns, overvaluation risks remain at the forefront of investor psyche. This reality is skewed by the stock market’s sizzling returns in 2019, but much of that is due to a lack of viable alternatives for investors.

One of the primary reasons portfolio managers are moving capital into stocks is a lack of better alternatives. In investment speak, this is called TINA, an acronym for ‘There is No Alternative.’ Analysts have warned that the ‘growth-for-the-sake-of-growth’ strategy is unlikely to succeed in the long run as equity values diverge from fundamentals.

A recent report from Morgan Stanley argued that U.S. markets will run out of steam over the next decade due to low interest rates, weak earnings and a never-ending growth recession. Analysts at the bank foresee annual returns of just 2.8% for portfolios with an almost equal balance of U.S. stocks and bonds. That’s barely enough to keep up with inflation, which the Federal Reserve targets at 2% annually (and that’s just the ‘core’ rate).

As MarketWatch contributor Mark Hulbert recently noted, “not all valuation measures tell the same story.” But even for investors who aren’t convinced that the market is overvalued, recent actions by the Federal Reserve should be cause for alarm.

The U.S. central bank has not only shaved 75 basis points off the federal funds rate since July, it’s conducting emergency repo operations to shore up liquidity in the inter-bank lending system. Such activity foretells serious trouble ahead despite all the claims of a healthy economy.

This article was edited by Josiah Wilmoth.

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