As we approach the new year, wealth advisors should consider reducing portfolio risk amidst signs of overvaluation in the equity markets, according to a recent analysis from Rosenberg Research.
Marius Jongstra, a strategist at the firm, warns that current stock valuations lack support from underlying fundamentals. Elevated prices, combined with lingering policy uncertainties ahead of President-elect Donald Trump's second term, make this an inopportune moment to pursue aggressive risk strategies.
“This is not the time to indiscriminately chase higher equity exposure,” Jongstra emphasized in a Monday briefing. “With significant policy uncertainty on the horizon, it’s prudent to scale back risk and adopt a selective approach to market participation.”
This cautionary stance is not new for Rosenberg Research, which has consistently highlighted the risks of stretched valuations. However, recent metrics suggest that market indicators are nearing extremes last observed in 2021—a year that preceded a steep 25% bear market correction in 2022.
Jongstra referenced the firm’s proprietary "bubble indicator," a comprehensive gauge that assesses valuations, margin debt, cash balances, and investor sentiment. This indicator has steadily climbed from late 2022 lows, reaching a reading of 1.29 in November. While still below the all-time high of 1.72 recorded in 2000, it is approaching the 2021 peak of 1.33, signaling elevated levels of exuberance and leverage.
The Shiller CAPE ratio, a well-regarded valuation measure that adjusts for earnings over a trailing 10-year period, corroborates this view. The S&P 500’s current CAPE ratio stands at 38.1x “normalized” earnings, just shy of the 38.3x high reached in December 2021. If this ratio surpasses the critical 40x threshold—a rarity that has occurred in only 2% of historical instances—it could signify a heightened risk of negative returns. Jongstra's analysis indicates that such overvaluation has historically resulted in average annual losses of approximately 3% over one-, five-, and ten-year horizons.
“Momentum can propel markets to levels well beyond expectations,” Jongstra observed. “However, when investor confidence becomes excessive and leverage is employed to amplify returns, the risk to long-term performance escalates. Elevated valuations paired with high leverage create a precarious environment for forward returns.”
This cautious outlook aligns with recent warnings from other market strategists. David Kelly of JPMorgan Asset Management and Barry Bannister of Stifel have both raised concerns about the sustainability of current valuation levels.
Nevertheless, some analysts maintain that higher valuations are justified, particularly given structural changes in market composition. In a recent note, UBS analysts argued that the increasing dominance of technology companies within the S&P 500 supports elevated valuations. These firms have demonstrated superior top-line growth and profitability margins compared to their non-tech counterparts, justifying their premium pricing in the eyes of some investors.
As the new year unfolds, wealth advisors and RIAs should remain vigilant, balancing the potential for continued momentum with the growing risk of overvaluation. A disciplined, selective approach to equity exposure will be critical in navigating the uncertain market terrain ahead.
