Citi warns stock market rally looks ‘unsustainable’ as S&P 500 enters ‘new undervaluation regime’


According to Citigroup Inc., this year’s stock market rally has pushed the S&P 500 to valuation levels that make it difficult for the index to climb higher given the current macroeconomic environment.

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

On Tuesday afternoon, the SPX index, investors Martin Luther King Jr. U.S. stocks have risen so far this month, with the S&P 500 up 4.2% through Friday as they head into a three-day weekend in honor of.
-0.20%
It was trading around 3,994, down 0.1% at last check, according to FactSet data.

“For now, we suspect that valuation will put a near-term cap on the rate of upside,” Citi analysts said. “Based on our fair value framework, valuations well above current levels are unsustainable in the absence of a significant change in the macro backdrop.”

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

“This means that in this new environment, index gains should be ‘earned’ against near-to-medium-term fundamental improvement, less the macro tailwinds behind multiple re-ratings caused by lower interest rates,” the analysts wrote. .

Citi’s fair value framework, based on current rates and other “macro inputs” such as inflation and growth, assumes an S&P 500 price-to-earnings ratio of 18.5 times, according to the report.

“A more aggressive deceleration in inflation to 18-19x is pushing the limits of fair value unless we can combine with significantly lower rates and other better macro readings,” the analysts said.

The chart below shows Citi’s fair value range for the S&P 500 versus the index’s price-to-earnings multiple since 2021.

CITI INVESTIGATION RECORD DATED JANUARY. 13, 2023

Citi analysts pointed to recent client talks and said there was “little confidence that interest rates will fall further from current levels.” This is “consistent with the view that the Fed is less likely to switch from hawkish to dovish in a shorter time frame.”

The Federal Reserve has been rapidly raising interest rates to combat high inflation, with many investors expecting the Fed to potentially hold off on rate hikes this year as the rising cost of living in the US shows signs of easing.

As rates rose last year, the S&P 500 shed 19.4%, its worst performance since 2008.

Citi analysts said: “From our ongoing view, we are confident that rate-based valuation headwinds may persist, adding more weight to earnings trajectories.”

“The sell-side consensus appears to be coalescing around a weak first half, strong second half story,” they said. “We’re more constructive in the second half, like many of our peers, but we don’t see the same downside pressure on earnings and the upside to valuations that others expect.”

Analysts said, citing expectations for a decline in S&P 500 earnings per share this year, “this could hamper the momentum.”

U.S. stocks were trading mixed on Tuesday afternoon as investors weighed Goldman Sachs Group Inc . They digested the fourth quarter earnings results from GS.
-6.44%
and Morgan Stanley. Morgan Stanley MS,
+5.91%,
beating earnings estimates, was the best performer in the S&P 500 with a gain of more than 7% late Tuesday afternoon, according to FactSet data at last check.

Read: Goldman Sachs misses earnings estimates, while Morgan Stanley misses profit estimates

As for other major US stock market indicators, the tech-heavy Nasdaq Composite COMP,
+0.14%
The Dow Jones Industrial Average DJIA was up 0.1% in midday trading on Tuesday,
-1.14%
It was down 1.1% at last check, according to FactSet data.

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

While Citi’s year-end target of 4,000 for the S&P 500 was below the average strategist’s expectation, estimates for the index to see earnings of $216 per share were “beatable,” they said. “We said differently that we expect the market to be closer to 18x at the end of the year versus around 20x.”

Read: Small-cap stocks have outperformed year-to-date in 2023 as U.S. stocks posted gains for the second week of the year.

See also: ‘Two and a half years’: Stifel’s Barry Bannister expects near-term rally in US stocks – and then trouble in 2023



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