The ongoing rally in the stock market could become unsustainable if a melt-up happens, according to market veteran Ed Yardeni.He observed that as investors turn more bullish on stocks, the Federal Reserve is staying hawkish.”Valuations are getting stretched again,” Yardeni warned clients in a Monday note. Loading Something is loading.
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While once-skeptical investors are increasingly turning bullish on the stock market, the Federal Reserve continues to telegraph a hawkish message to markets.
That’s a troubling dynamic, and it could ultimately lead to a melt-up in the stock market if equities continue to jump higher, according to a Monday note from market veteran Ed Yardeni.
He observed that with the S&P 500 trading just below the 4,500 level, it’s not far off from his year-end target of 4,600. Meanwhile, the Nasdaq 100 surged 38% in the first half of the year, representing its best start to a year since 1983.
“And it is only mid-year!” Yardeni said. “The S&P 500 is 11% above its 200-day moving average. It should find some resistance at its current level, which coincides with the upper bound of its bullish channel. If it rockets even higher, a melt-up scenario becomes more likely.”
A melt-up rally in the stock market would be concerning to investors because such rallies are typically unsustainable and ultimately give way to painful losses on the other side, especially when valuations are already elevated.
“Valuations are getting stretched again,” Yardeni said, highlighting that the forward price-to-earnings ratio of the mega-cap tech stocks is back over 30x. Meanwhile, the S&P 500 is trading at a forward P/E ratio of 19x, and 16.5x when you exclude the mega-cap tech stocks. That’s still not cheap.
“Since the start of the bull market, the MegaCap-8 are up a whopping 47.2%,” Yardeni said.
While Yardeni remains bullish on stocks, he points out a concerning trend of investors getting more bullish while the Fed turns more hawkish. A resilient economy has muted skepticism, as evidenced by an increase in bullish responses to the AAII weekly investor sentiment survey.
Meanwhile, the Fed Chairman Jerome Powell telegraphed last week that two more interest rate hikes are likely, even though the market is currently only pricing in one increase.
The mismatch between what the market expects versus what the Fed is saying could represent downside for the stock market, especially if new inflation data proves to be sticky.
For a healthy, sustainable rally that isn’t indicative of a “melt-up,” more sectors of the market need to begin participating in the ongoing move higher. According to Yardeni, that is starting to happen.
“There’s room for the rally to broaden out to financials. Meanwhile, the rally has already broadened out to the Industrials sector, which seems to be breaking out to new record highs,” Yardeni said.