Source: Barron's Weekly Author: Ed Lin The second largest public retirement fund in the United States recently made significant adjustments to its stock investment portfolio listed in the United States. The California Teachers' Retirement Fund increased its investment in Chinese e-commerce company, pdd holdings (PDD.US), and bought more shares of Discover Financial Services (DFS.US) and Williams-Sonoma (WSM.US) in the first quarter, while reducing its holdings of American Airlines (AAL.US) stocks. The California Teachers' Retirement Fund disclosed this stock trading information in a report submitted to the Securities and Exchange Commission. "Our public equity investment portfolio uses both passive and active strategies," the California Teachers' Retirement Fund said in a statement responding to a review request. "The portfolio's positions may change for various reasons, including fund managers' realignments of the active or index weights they require, or as a result of corporate mergers, stock splits, name changes or similar company actions." As of April 30, the fund managed assets of about $332.5 billion, making it the second largest public pension fund in the United States in terms of assets under management.

Six months ago, ordinary investors might have been willing to pay $5 for each future $1 profit of the S&P 500 index, and now they are prepared to pay more.

This is basically what is happening in the U.S. stock market. As of last week, the S&P 500 index's forward P/E ratio, based on expected profits for the next year, was 20.57 times, up 3.4 points from the low point in October last year. It is rare for the S&P 500 index's P/E ratio to rise so sharply in a short period of time. David Rosenberg, a well-known Wall Street strategist, wrote in a report that the probability of this occurring in the past 30 years is only 5%.

In a fundamentally sound market, the pace of corporate profits and valuation expectations is usually consistent. However, this year the expected EPS for the S&P 500 index is only about $0.5 higher than the forecast in early January, at $243.33 per share.

So why are ordinary investors still willing to push up the stock market's valuation?

This is where the stock market has been confusing this year. Although some star strategists argue that such valuations are unreasonable, they have raised their target prices for the S&P 500 index to go along with the increasingly bullish sentiment and to avoid making mistakes. The stock market's valuation has exceeded the historical average level of the past 25 years. Morgan Stanley's Mike Wilson wrote in a recent report, "To be honest, our ability to predict the P/E ratio has been poor over the past year. Although we were confident that valuations were too high, we have almost no confidence in predicting the exact time or degree of value restoration to a more normal level." He raised his target price for the S&P 500 index for the next 12 months from 4,500 points to 5,400 points.

The main reason for the rise in the S&P 500 index's valuation is that investors have pushed up the prices of technology stocks (largely driven by optimism about artificial intelligence), and the future P/E ratio for the technology 'Big Seven'---Nvidia (NVDA), Apple (AAPL), Amazon (AMZN), Microsoft (MSFT), Alphabet (GOOGL), Tesla (TSLA), and Meta Platforms (META)---for the next 12 months is currently 30.71 times.

Positive factors: liquidity and the 'Big Seven'

Liquidity is one reason why investors continue to push up the stock market's valuation. Many indicators show that there is money available in the market to invest in stocks, which has pushed up valuations further. Money market funds are the most frequently mentioned places where investors deposit cash. The total asset value of money market funds reached $6 trillion for the first time in February, and the latest data as of the week ending May 29th still exceeds this record.

This money, which is usually invested in short-term bonds (such as short-term U.S. government bonds), can be used to buy stocks at any time, thus forming a feedback loop. Other liquidity indicators also show that funds in the financial system are at a relatively healthy level: overnight reverse repo balances are $440 billion, and M2 money supply is currently hovering around $21 trillion.

More money in circulation also means that investors have the ability to take on more risk. The main reason for the rise in the S&P 500 index's valuation is that investors have pushed up the prices of technology stocks (largely driven by optimism about artificial intelligence)，and the future P/E ratio for the technology 'Big Seven'---Nvidia (NVDA), Apple (AAPL), Amazon (AMZN), Microsoft (MSFT), Alphabet (GOOGL), Tesla (TSLA), and Meta Platforms (META)---for the next 12 months is currently 30.71 times.

According to Dow Jones Market Data, the P/E ratio of the 'Big Seven' has risen 3.8 points from the low point in October last year, higher than the average level over the past 10 years. This indicates that the high valuation of the S&P 500 index is largely due to technology stocks.

This view is further confirmed when observing the S&P 500 equal-weighted index. As of last Friday (May 31), the forward P/E ratio for the next 12 months was 16.31 times, which is roughly consistent with the 10-year average level, although it has increased slightly from the level in October last year. This indicates that the valuations of some companies are returning to a more normal level.

Investors may also have to stay in the market longer due to the factor of price momentum. As the S&P 500 index continues to set new highs, the phenomenon of stock market 'exuberance' appears. In the first half of this year, the index set 24 closing highs, and few people are willing to sell, which means that in order to attract sellers, buyers must constantly pay higher prices for each $1 of profit. But prosperity does not necessarily mean logic. Rosenberg told Barron's, 'The stock market has always been a reflection of animal spirits, emotions, and speculation, and has nothing to do with the economic background. It will only show you irrationalism.' Rosenberg quoted economist Alan Greenspan's term 'irrational exuberance' to describe the behavior of the stock market in 1996.

"Irrational prosperity" is a more straightforward way of explaining overvalued valuation, which means that if inflation is too high or the profits of star companies in the field of artificial intelligence fail to meet market expectations, the stock market will face a significant risk of decline. In terms of product structure, the operating income of 10-30 billion yuan products is 401/1288/60 million yuan, respectively, with an overall sales volume of 18,000 kiloliters in 23, a year-on-year increase of +28.10%, showing significant growth.

Negative Factors: Macroeconomic and Fed

The US stock market fluctuated on the first trading day of June, and some market watchers expect more volatility in the stock market this summer.

In recent years, the US economy and stock market have maintained a fairly strong momentum. People used to think that the time for recession has been postponed, and now it is expected that recession will not come at all.

Bulls can give many convincing call reasons, but it is definitely not wise to ignore potential warning signs. Some Wall Street strategists warn that more warning signs are emerging.

Tom Essaye, founder of Sevens Report, said, "My biggest concern about the US stock market is still an unexpected slowdown in the US economy. Economic slowdown is one of the few events that could cause a sharp pullback in the stock market." Essaye pointed out that corporate earnings reports have exacerbated his concerns.

While the appearance of corporate profits has been relatively strong, Essaye believes that this is more because companies have controlled costs and adapted to market realities, namely, many consumers have become more picky and put pressure on demand, leading to spending cuts in all industries from Workday (WDAY) to American Airlines (AAL) to Lululemon (LULU).

However, in a market environment that is eagerly waiting for the Fed to cut interest rates, there will always be some people who view bad news as good news because they believe that any signs of economic weakness will give the Fed a reason to cut interest rates.

But Essaye warned that things are not that simple. Essaye said, "In my career, I have seen investors cheer for economic slowdown twice, and both times the Fed failed to cut interest rates at the right time to prevent economic slowdown from turning into more widespread economic contraction. This is not to say that the Fed cannot grasp the right time to cut interest rates this time, but 'catching a falling knife' does not work in real life, does not work in stock trading, and I have never seen it work in monetary policy."

Essaye is not the only one who worries that optimists are ignoring major risks.

Andrew Brenner, director of international fixed income at National Alliance Securities, pointed out that more and more evidence shows that the Fed may be "too focused on inflation and ignoring the weakening US economy."

Brenner believes that the US economy is bound to weaken. He said, "The US economy is weakening, and what the economy is experiencing is not a recession, but it is weaker than before." This is evidenced by a decline in consumer confidence and a decrease in consumer spending after adjusting for inflation.

This view echoes other views quoted in last week's Barron's report. Some strategists warn that given the increasingly bearish factors, especially high interest rates and high US Treasury yields, the trend of the stock market may be volatile at least this summer.

Scott Chronert, a strategist at Citigroup, believes that if the S&P 500 index is valued only according to broader macroeconomic trends, a valuation of about 4,000 points would be completely reasonable, which is far from the current position of slightly less than 5,300 points.

However, fortunately, this is not the only relevant indicator. Chronert's previous research showed that the correlation between earnings of S&P 500 index constituents and GDP has declined, and at the same time, various factors, from productivity improvements associated with technology to the trend of incorporating artificial intelligence into various industries, will push profits further. Therefore, Chronert believed that this means that "the sensitivity of fundamentals to the economy is lower than historical levels, and stronger profitability is expected to support higher valuations."

In view of this, Chronert believes that although the macroeconomic background is mixed, the S&P 500 index may rise to 5,500 to 6,200 points because structural favorable factors can boost profits ahead of GDP growth.

Essaye also believes that if bond yields fall, it is not ruled out that the S&P 500 index will rise to or above 5,700 points, and currently investors are beginning to focus on the earnings per share of the S&P 500 index in 2025, with expected earnings per share increasing from $243 this year to $270.

In the past, the US stock market has also risen in the situation where many worrying signals are ignored, so it is not impossible for the stock market to continue to rise. However, if the stock market encounters a "summer doldrums", bleak economic data will not help the stock market accelerate its rise again.

Editor / jayden