Stocks are poised for something that hasn't happened since the days of the dot-com bubble

By Joseph Adinolfi

It's raising questions about how much longer the rally can continue at its current pace

The S&P 500 is flirting with what would be a rare accomplishment: rising 20% or more during two consecutive calendar years.

At least, that was the case as of Tuesday's close, when the U.S. benchmark saw its year-to-date advance top 20% for the first time since the start of 2024, according to Dow Jones Market Data. The achievement happened to coincide with the index's 41st record close of the year.

By the time trading ended on Wednesday, the S&P 500 had pulled back a bit. But it remains close to its high, and in the wake of the Federal Reserve's jumbo interest-rate cut, investors have good reason to expect that it will get there.

It's been a while since the index has seen such strong years back to back. The last time it happened was 1998, according to Dow Jones Market Data. In those days, burgeoning public enthusiasm for stock trading and the hype unleashed by the advent of the commercial internet helped the S&P 500 SPX appreciate by 20% or more for four straight years beginning in 1995. The streak nearly continued for a fifth year, but the index rose by just 19.5% in 1999.

Prior to that, stocks hadn't seen such strong gains for two years in a row since 1955, before the S&P 500 had even been introduced.

The strength of stocks' advance has helped to revive speculation surrounding how much further large-cap U.S. stocks can climb, and whether the stunning bull-market run - which has seen the S&P 500 gain 60% since its October 2022 low, according to FactSet data - might be poised to slow, or even reverse.

Some have suggested abandoning large-cap stocks altogether in favor of better deals in the small- and medium-cap space, or even going bargain-hunting abroad.

But others insist that large-cap stocks are still investors' best bet, even as their valuations have reached levels considered high relative to recent history.

Echoes of the dot-com days

The implicit comparison to the dot-com bubble days isn't exactly a ringing endorsement. Wall Street professionals are quick to highlight the differences between now and then, as well as the similarities.

"It's interesting that the last time we've seen performance like this was the late '90s," Steve Sosnick, chief strategist at Interactive Brokers, said during an interview with MarketWatch on Wednesday.

"I don't want to overstretch the analogy to the internet era, because that's not necessarily fair, but what I would say is that was also a time when the public fell in love with stocks," he said. "As a result, you know, they were willing to really put money into the markets."

Then as now, technology stocks are dominating the market. Taken together, information technology and communications services - the successor to the telecoms sector - account for an outsize share of the S&P 500's market value, according to Eric Wallerstein, chief markets strategist at Yardeni Research.

Based on where stocks are trading relative to companies' sales, the S&P 500 is even more expensive today than it was back then, FactSet data show. The forward price to sales ratio for the S&P 500 stood at 2.9 times as of the end of August, compared with 2.4 times in late 1999.

But the biggest American companies of today are also more profitable than they were back then, meaning prices compared with expected future earnings are actually lower.

Based on Wall Street's profit forecasts over the next year, the S&P 500 recently traded at a ratio of 21.6 times forward earnings, compared with just under 24 times in late 1999.

The valuation question

While metrics like price to sales are harder for companies' management teams to manipulate, at the end of the day, profits are what matter to investors, Sosnick said.

Still, some on Wall Street believe elevated valuations are likely setting the stage for the S&P 500 to deliver below-average returns over the next decade.

See: Investors should brace for lower stock-market returns over the next decade, JPMorgan warns

Earlier this month, a couple of analysts at J.P. Morgan Securities warned that, based on their models, the S&P 500 would see its average return over the coming decade shrink to 5.7%. That's lower than the average annual return of 8.5% for the S&P 500 since it was introduced in 1957, according to Dow Jones data.

Taking the other side, Wallerstein and his colleagues at Yardeni Research believe S&P 500 earnings - and therefore returns - will be supported by higher-than-expected economic growth through at least 2030.

Improving productivity should help corporate profit margins for the biggest companies continue to expand, which in turn should help propel the market higher at an above-average pace.

"I think one reason why valuations can be higher today and going forward is that an increasingly large part of the market is the Magnificent Seven, or [information technology] and communications services," Wallerstein said during an interview with MarketWatch.

"We don't take the valuation argument lightly, but it's an argument that you could have been making for the past 15 years," he added.

Broadening out

That isn't to say that tech and tech-adjacent stocks will continue to dominate the market to the extent they did in 2023 and earlier in 2024. Indeed, that has already started to change since the start of the third quarter.

Wallerstein said he sees plenty of signs that other large-cap stocks have started to make greater contributions. As long as former laggards like financials, industrials and utilities - which are closing in on their best quarter since 2003, data show - continue to rally, there's plenty of scope for the index to keep on climbing at a brisk pace.

As of earlier this week, the percentage of S&P 500 companies outperforming the index stood at about 34%, according to Dow Jones data. That's up from 29% for calendar year 2023. Over the past decade, the average has been 46.2%, excluding this year.

History suggests the good times for stocks can continue, albeit at a slower pace. Since 1957, the S&P 500 has seen an average gain of just over 9% during the year after a 20% return, according to Dow Jones data.

The S&P 500 fell by 10.67 points, or 0.2%, on Wednesday to 5,722.26, according to FactSet data. The Nasdaq Composite COMP, meanwhile, eked out a marginal gain to close at 18,082.21.

The Dow Jones Industrial Average DJIA shed 293.47 points, or 0.7%, to finish at 41,914.75.

Ken Jimenez contributed.

-Joseph Adinolfi

This content was created by MarketWatch, which is operated by Dow Jones & Co. MarketWatch is published independently from Dow Jones Newswires and The Wall Street Journal.

(END) Dow Jones Newswires

09-25-24 1656ET

Copyright (c) 2024 Dow Jones & Company, Inc.