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The Street

Business

Dan Weil

Veteran fund manager sees world of pain coming for stocks

Doug Kass US Federal Reserve FactSet

Stocks have hit the jackpot over the past two years, with the S&P 500 index soaring 44%. It has hit multiple record highs this year.

Now the argument is raging between bulls and bears: will the party roll on, or is it time for a significant pullback?

Bulls see the Federal Reserve trimming interest rates, perhaps twice this year. That would stimulate the economy and boost corporate earnings.

Easing inflation will allow the Fed to act, they say. Consumer prices climbed 3.4% in the 12 months through May, the lowest reading in more than three years.

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Bulls note that earnings already are on the upswing. Profit grew 5.9% per share for the S&P 500 in the first quarter from a year earlier, according to FactSet.

Analysts forecast an 8.8% increase for the current quarter. If that turns out to be true, it would represent the largest gain since the first quarter of 2022.

The Bearish Case

But bears say that’s an over-estimate. And the market’s surge has gone too far in any case, they contend.

As of June 14, the forward price-earnings ratio for the S&P 500 totaled 21, well above the five-year average of 19.2 and the 10-year average of 17.8, according to FactSet. “Forward” means the ratio is calculated with analysts’ estimates of earnings for the next 12 months.

Bears also expect the Fed to leave interest rates “higher for longer.” The latest forecast by Fed officials produced a median estimate of only one rate cut for this year.

And inflation remains sticky, the bears say. The personal consumption expenditures price index, which is the central bank’s favored inflation indicator, registered 2.6% in the 12 months through May. That’s down from 2.7% in April but still well above the Fed’s target of 2%.

Doug Kass’ view on stocks

Hedge fund manager Doug Kass, author TheStreet Pro's Daily Diary, represents one of the bears. His opinion is well qualified given his career as a hedge fund manager going back to the 1970s. That includes a stint as director of research at legendary investor Leon Cooperman's Omega Advisors.

The market is “flying too close to the sun,” Kass wrote in a Street Pro commentary. He was referring to the mythological character Icarus, whose wings melted when he flew too close to the sun.

Here are three of Kass’ negative points.

1. Interest rates have risen, and the equity risk premium is at a multi-decade low, he notes. The 10-year Treasury yield has jumped 0.57 percentage point to 4.44% so far this year.

The equity risk premium is the excess return provided by investing in the stock market over investing in Treasuries.

The current low premium means investors don’t see much advantage in investing in stocks over Treasuries. That indicates equities could fall.

Meanwhile, the S&P 500 dividend yield totals only 1.29%, compared to a 5.3% yield for six-month Treasuries.

It is a rare event for the Treasury yield to be nearly four times that of the S&P 500, Kass pointed out. Falling stock prices would push the dividend yield higher, of course.

The Fed, top heavy performance

2. Investor expectations for Fed rate cuts have declined to one or two reductions this year, compared to forecasts earlier this year of six cuts.

3. “Equity performance has been top heavy, with five large-cap technology companies skewing returns,” Kass said.

Semiconductor sultan Nvidia (NVDA) has accounted for 35% of the S&P 500’s gain so far this year, he said.

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The other four are search king Alphabet (GOOGL) , social media titan Meta Platforms (META) , software stalwart Microsoft (MSFT) and retail/technology colossus Amazon (AMZN) . They account for 26% of the S&P 500’s return this year.

“Not since the 1960s have five stocks accounted for so much (61%) of the total market return,” Kass said. “We should learn from history as these divergences have ended badly and unexpectedly.”

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