Investors are growing increasingly bullish on the stock market, but there is a concerning divergence between their optimism and the hawkish stance of the Federal Reserve. This discrepancy could potentially lead to an unsustainable rally in the stock market, known as a melt-up, warns veteran market analyst Ed Yardeni.
Yardeni notes that the S&P 500 is currently trading just below the 4,500 level, not far off from his year-end target of 4,600. Additionally, the Nasdaq 100 has surged 38% in the first half of the year, marking its strongest start to a year since 1983.
The current situation raises concerns because melt-up rallies are typically short-lived and usually result in significant losses when valuations are already inflated. Yardeni points out that valuations are becoming stretched again, with the forward price-to-earnings ratio of mega-cap tech stocks surpassing 30x. The S&P 500, excluding mega-cap tech stocks, is trading at a forward P/E ratio of 16.5x, which is still relatively high.
While Yardeni remains optimistic about stocks, he highlights the worrisome trend of investors growing more bullish while the Federal Reserve adopts a hawkish position. Although the resilient economy has dampened skepticism, there is a disparity between what the market expects and what the Fed is signaling. Federal Reserve Chairman Jerome Powell recently suggested that two interest rate hikes are likely, whereas the market is currently only pricing in one increase.
This mismatch could spell trouble for the stock market, especially if new inflation data proves to be persistent. For a sustainable rally that avoids a melt-up scenario, Yardeni emphasizes the need for more market sectors to participate in the current upward trajectory. He believes the rally could broaden to include financials, while the industrials sector has already shown signs of breaking out to new record highs.
In summary, while investors are increasingly optimistic about the stock market, the Federal Reserve’s hawkish stance raises concerns about the sustainability of the current rally. Valuations are already stretched, and a melt-up scenario could lead to significant losses. The discrepancy between market expectations and the Fed’s signaling adds further uncertainty. To ensure a healthy and durable rally, more sectors need to participate in the market’s upward movement. The situation warrants careful observation and consideration of potential risks.
