The S&P 500’s rally has stalled since August — yet despite the slowdown, stocks look anything but cheap these days.
“It’s nearly impossible to be bullish on the market capitalization weighted S&P 500 on valuation – it trades expensive on 19 of 20 measures we track,” wrote Bank of America equity & quant strategist Jill Carey Hall in a recent note to clients. “Our Dividend Discount Model Equity Risk Premium is the only measure on which the US market trades inexpensive, aligned with our view that the risk premium for stocks may be too high and the so-called “risk-free” 10 year T-bond rate may be too low.”
Although valuation matters in the long-run, sentiment has a more immediate impact on share prices, Carey Hall wrote. And ironically, while sentiment seems to be turning bearish right now, that’s exactly why stocks could rise dramatically within the next year.
Bad vibes mean good returns
While market-cap-weighted valuations may not look cheap, equal-weight valuations actually aren’t all that bad — particularly once you cut out the so-called Magnificent 7 that have dramatically outperformed the rest of the market this year.
Carey Hall noted that “based on the equal weighted S&P 500, PE ratios are roughly at historical average levels.” In fact, Carey Hall pointed out the S&P 500 only trades three standard deviations above its average when measuring PE to growth.
The reason for this is investor pessimism, particularly when it comes to long-term growth (LTG) expectations. Analyst consensus for LTG has nosedived since 2022, Carey Hall wrote, and are currently sitting near a record low just a few percentage points shy of the March 2020 trough.
But as it just so happens, low LTG expectations have historically been a strong indicator for positive future stock market returns.
“Low LTG has been bullish. In fact in November 2021, we cited lofty expectations as a bearish set-up, given the strong inverse relationship between LTG and future S&P 500 returns,” Carey Hall wrote. “Today’s LTG suggests >25% price returns over the next 12 months for the S&P 500, all else equal.”
6 industries where investors can find opportunities to profit
So, if the market can really rally over 25% in the next year, where should investors be putting their money now to maximize their returns?
Carey Hall noted that LTG expectations are surprisingly high in the communication services sector, considering that interest-rate increases are usually a problem for long-duration sectors. Meanwhile, energy’s expectations are shockingly low, she wrote, considering that energy earnings have risen 40% in the last three years.
All told, Carey Hall and her colleagues at Bank of America see opportunities ahead in six industries, predicated on three factors: price momentum, or the difference between an industry’s relative price this month vs. three months ago; earnings momentum, or the difference between relative forecast EPS this month and three months ago; and valuation.
According to Carey Hall, the best investment opportunities lie in the interactive media & services, household durables, media, passenger airlines, energy equipment & services, and insurance industries.
More broadly, she noted that the most attractive sectors right now are the communication services, energy, and consumer discretionary sectors.