With Stocks at Record Highs, What Could Go Wrong?

We Assign ‘Worry Rankings’ to Investor Concerns

The S&P 500 is up nearly 10% since its 2014 low in the first week of February. The index, which tracks the largest stocks, is now at a record high, up 4.1% for the year.

Behind the rebound is a view that stocks will continue to benefit from robust earnings, low interest rates and scant inflation. If those conditions persist, the market’s climb could very well continue.

But it’s important to examine the issues that have the worrywarts up at night and the justification bears have for their downbeat outlooks.

Below are some critical investor concerns, with a 1 to 10 “worry level” ranking—1 being the least worried and 10 the most.

Earnings and the economy: worry level 8.

The U.S. economy just can’t seem to take off, and recent earnings have disappointed. On Thursday, government data showed the nation’s gross domestic product declined at an annual pace of 1% in the first quarter, worse than economists expected and the first time economic output contracted since the first quarter of 2011.

Meanwhile, profits for S&P 500 companies in the quarter rose about 2% from the same period a year earlier, below the previous quarter’s 8.5% rise.

Rising prices for Treasurys are a sign the bond market is more skeptical about growth than the equity market.

The bond market is giving “a thumbs-down vote on economic growth,” says Peter Boockvar, chief market analyst at Lindsey Group.

Adds Daniel Alpert of Westwood Capital: “The bond and equity markets are expressing dramatically different views of the economy. When this happens, bonds typically have it right about 80% of the time.”

What the Fed might do: worry level 6.

A key reason stocks have done well since 2009: The Federal Reserve has kept interest rates low while buying huge volumes of bonds, trying to stimulate the economy. That’s forced investors to flee fixed-income investments and shift to equities.

But the Fed is paring its bond purchases and eventually will raise interest rates, raising questions about the market’s underpinnings.

How much should investors worry? The market is likely to shrug off the Fed’s activity until investors see an actual rate increase on the horizon, some say.

And until wages pick up, unemployment drops and inflation shows signs of heating up, the Fed is unlikely to raise interest rates. That could be at least a year away.

China and global growth: worry level 6.

Global growth is tied to growth in China, the world’s No. 2 economy, and there are huge questions about that economy. China’s property slump is deepening; the nation saw a 9.9% drop in housing values in the first four months of the year compared with a year earlier. Construction starts for housing fell 24.5% over the same period. Beijing and other big cities are seeing weakness lately, not just second- and third-tier cities.

How much should investors worry? Hopes are growing for India, where a new government has promised economic reforms, suggesting that Chinese weakness could be offset elsewhere.

Stock valuations: worry level 4

The S&P 500 currently trades at 16.7 times its earnings over the past 12 months, and 15.4 times expected profits over the next 12 months, according to FactSet.

These price/earnings ratios compare with an average P/E ratio over the past 10 years of 14.6 based on the past 12 months’ earnings, and 13.9 based on expected earnings over the next 12 months.

Lindsey Group’s Mr. Boockvar notes that small stocks, as measured by the Russell 2000 index, trade at an expensive 25 times earnings. Still, the market overall isn’t at exuberant levels.

Investor confidence: worry level 3.

Investor sentiment often can be a contrary indicator, notes Darren Pollock, portfolio manager of Cheviot Value Management. If too many are bullish on stocks, it could suggest few are waiting on the sidelines to get in.

When noted bears throw in the towel and become bulls, it also could be a sign that the market is in dangerous territory.

Here, too, some find a few reasons for some worry. “Bulls outnumber bears in a range that is close to levels that preceded the 2008 decline,” Mr. Pollock says, citing data from the Investors Intelligence Advisors Sentiment Index.

Dennis Gartman, a newsletter publisher who has long predicted a market pullback, shifted gears recently and told The Wall Street Journal he was wrong to expect a correction.

The bears raise important concerns, and the five-year bull market is getting long in the tooth, suggesting that investors are building cash positions. But it’s likely unwise to sell the bulk of a portfolio in June and leave the room.

“China worries are valid, though they may be overdone,” says Tobias Levkovitch, chief U.S. equity strategist at Citigroup. C +0.76% “And we do not see the bond market signaling a slowdown given credit conditions and leading indicators.

“People worry about margins and valuation but we’re less concerned about that.”

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