A few astute market watchers accurately anticipated that the recent pullback in U.S. stocks would not escalate into a more severe and prolonged selloff.
Last week, both the S&P 500 index (SPX) and the Nasdaq Composite (COMP) rebounded, ending a three-week streak of losses experienced earlier in the month. On Wednesday, U.S. stocks continued to trade higher, with the S&P 500 and Nasdaq poised for a fourth consecutive day of gains.
What set these market watchers apart? They simply turned their attention to the typically stable corporate bond market.
Since the beginning of August, analysts such as Ryan Detrick from Carson Group, Nicholas Colas from DataTrek, and Jeff deGraaf from Renaissance Macro noted that despite the stock market decline, spreads on lower-tier investment-grade corporate bonds remained largely unchanged.
These analysts focused on the yield spread between an index of BBB-rated U.S. corporate bonds (which is among the lowest investment-grade ratings) and U.S. Treasuries. As of this week, the spread between BBB-rated bonds and Treasuries has remained steady at just over 1.5 percentage points since the start of the month.
Interpreting this as a positive sign, the analysts concluded that the August stock market decline was driven primarily by technical and seasonal factors rather than a more significant underlying issue. If investors were demanding higher returns in the corporate bond market, it would have indicated a meaningful deterioration in their expectations for corporate cash flows and profits.
By the time stocks reached their peak for 2023 in the previous month, analysts throughout Wall Street were cautioning clients that the market appeared to be overheating. Tom Lee from Fundstrat and other analysts warned of a potential August pullback.
Many analysts pointed to the S&P 500’s price-to-earnings (P/E) ratio as evidence of stretched valuations. According to FactSet data, the forward P/E ratio for the S&P 500 reached its peak at 19.78 on July 19 and remained around that level until August 1. Since then, it has fallen to 18.96 based on the latest available data.
Forward P/E Ratio: A Key Indicator for Valuing Stocks
The forward price-to-earnings (P/E) ratio is a crucial metric used to determine the value of stocks or stock-market indexes. It provides insights into how much corporate profits are expected to grow in the upcoming year. On Wall Street, this ratio is considered a standard measure for comparing stocks and indexes on an apples-to-apples basis, going beyond just the stock price.
Currently, the S&P 500’s forward P/E ratio stands at 18.96. While this figure is above its five-year average of 18.6 and its 10-year average of 17.4, indicating that stocks may be slightly overvalued compared to recent history.
Looking ahead, experts like Detrick warn that stocks could face the typical seasonal downturn in September. Historical data reveals that September has historically been the worst month for stock-market returns. Since 1945, the S&P 500 index has consistently delivered an average monthly return of negative 0.73% in September, making it the worst-performing month of the year.
For investors, it is crucial to keep an eye on the bond market during this period, according to Detrick. Despite the potential challenges in September, the credit markets currently show minimal signs of stress. This suggests that a significant stock market meltdown, often exaggerated in media predictions, is not to be expected, as per Detrick’s written commentary published online.
Although both the S&P 500 and Nasdaq Composite are projected to incur monthly losses – with the S&P 500 on track for a 1.6% drop and the Nasdaq set to fall by 2.2% – it is important to note that they had seen significant gains earlier in the year. While the S&P 500 was up approximately 20% year-to-date at its peak in July, it maintains a strong year-to-date increase of 17.7% as per Wednesday’s FactSet data.
On Wednesday, US stocks were experiencing an upward trend, with both the S&P 500 and Nasdaq set to extend their positive streak for the fourth consecutive day.