Is the stock market getting ahead of itself?

After 5 straight months of stock gains, is the market getting ahead of itself?

The market is running hot right now. Valuations are stretched in certain pockets, like Big Tech. Stock sentiment indicators have accelerated quickly. And the S&P 500 Index and NASDAQ Composite Index are trading well above their major moving day averages. Investors shouldn't be surprised if stocks take a needed breather or experience a pullback of 5% to 10% at some point in the second half.

Notably, August has produced generally flat returns on average for the S&P 500 over the last 20 years but with a fair amount of volatility in performance year-to-year. And September is one of only three months where average returns for the S&P 500 are flat-to-negative on average over the last 20 years. Bottom line: S&P 500 seasonality patterns across August and September are less favorable from a historical perspective. That's not to say other items (inflation, interest rates, growth and profits) won't be more influential in driving stock prices across the final days of summer, but seasonality patterns now turn into headwinds for the bulls. A little added volatility wouldn’t be too surprising after a strong period of gains.

However, such consolidation or a downturn in the market is healthy and normal. Given that roughly $5.5 trillion is sitting in money market funds today, and some investors have been caught off guard by the run-up in stock prices this year, we suspect such a pullback could be welcomed by those who want to get more onside with their equity exposure. Thus, near-term pullbacks in the market, should they develop, could be shallow as investors put money back to work in equities.

Should investors position portfolios differently today and in preparation for a period of consolidation or a possible downturn?

The optimal strategy for investors today is to align their portfolio and investments with their longer-term goals and risk tolerance. A generally balanced portfolio can help take advantage of the opportunities that arise when stocks move off their lows, as they have done over several months. It can also insulate risk if stocks move through periods of consolidation or brief downturns. 

At this point, there are opportunities for further gains in the stock market, but investors should be realistic about how far stock prices can push higher, given elevated recession risks and still above-normal inflation levels. Investors will want to keep portfolio changes small against their longer-term strategies, as short-term market timing seldom outperforms a stay-the-course approach. 

With risks and opportunities in the market generally balanced, portfolios should also reflect a generally balanced yet cautious approach. And with yields at highs last seen in over a decade, fixed income finally offers competitive returns in a portfolio — a new phenomenon for many younger investors. Older investors should again welcome the opportunity to generate income on more conservative investments.

What conditions could influence stock prices over the coming months?

If the Fed overtightens policy and/or inflation remains sticky (particularly on the core side), financial conditions could deteriorate more than the market is currently pricing. Similarly, on the corporate profit side, if the economy increasingly looks like it may enter a recession over the next 6–12 months, current S&P 500 earnings estimates do not reflect a recession scenario. Thus, profit estimates for future quarters may have to come down, which could pressure stock prices.

At the same time, if the Fed engineers a soft landing, inflation continues to ease and central bankers can move to the sidelines, possibly cutting rates sometime in 2024, then stock prices have an opportunity to move higher. And if analysts appear correct about the profit backdrop next year, then we believe stocks are reasonably priced based on next year’s earnings, suggesting stocks may have more upside potential.

But both conditions are plausible as it stands today and, in our view, appear balanced in their odds of occurring. As a result, investors should keep portfolios broadly balanced between stocks, bonds, cash and alternatives versus their longer-term targets.

Fitch recently downgraded the U.S. debt rating — should investors change their allocations to U.S. government debt?

The short answer is no. This month, Fitch downgraded the U.S. credit rating to AA+ from AAA. Fitch noted an “expected fiscal deterioration over the next three years, a high and growing general government debt burden and the erosion of governance relative to AA and AAA peers” as reasons for the downgrade. The recent move — which came several months after the resolution of May’s debt ceiling standoff — was somewhat surprising, given no new fiscal information was at the heart of the downgrade. 

The last time the U.S. debt rating was downgraded was by Standard & Poor’s in 2011 amid a similar debt-ceiling skirmish. Following the 2011 downgrade, the S&P 500 fell nearly 7.0% on Aug. 8, 2011 (the first trading day after S&Ps announcement), with the stock benchmark losing roughly 6.0% that August and over 7.0% in September. Thus far, market action has been more muted. Moody's, the other large credit ratings firm, continues to hold the U.S. at its strongest rating. 

Bottom line: The fiscal challenges the U.S faces are well documented and could pose issues for the government and economy in the years to come. However, the Fitch downgrade is unlikely to affect U.S. borrowing costs, as U.S. government debt and its currency remain one of the safest investments in the world. Notably, U.S. Treasuries are the benchmark asset for safety and liquidity. We believe nothing about Fitch's downgrade or its rationale changes that point. Large holders of U.S. Treasuries (professional investors, institutions and governments) are highly unlikely to change their allocations or investment thesis on U.S. debt because of Fitch’s downgrade. Retail investors should follow a similar view. 

That said, it’s a good reminder that rating agencies are growing more concerned with the U.S. political system, increasing debt burdens and the general unwillingness to tackle key items around our debt burden, such as Social Security and Medicare/Medicaid.

Your Ameriprise financial advisor is here to help

If you have questions about how to position your investment portfolio in light of the current market environment, reach out to your Ameriprise financial advisor.