While analysts are currently very optimistic about the market, the combined risk of high valuations and the need to rebalance portfolios in the short term may pose an unanticipated threat. This is particularly the case given the current high degree of speculation and leverage in the market. It is fascinating how quickly people forget the painful beating of taking on excess risk and revert to the same thesis of why “this time is different.” For example, I recently posted on “X,” which showed a visual of the 2021 market surge versus 2023-2024. While this time is may be different, don’t be surprised if it ends the same.

How soon we always forget. pic.twitter.com/pbfLwlsTjJ

— Lance Roberts (@LanceRoberts) December 6, 2024

One of the near-term risks to more bullish investors is the combination of high stock valuations and the necessity of portfolio rebalancing, which could impact market stability. Using 2023 data, it is estimated that mutual funds in the United States held approximately $19.6 trillion in assets, while exchange-traded funds (ETFs) managed about $8.1 trillion, suggesting a substantial number of portfolios containing combinations of stocks and bonds.

With the year-end approaching, portfolio managers need to rebalance their holdings due to tax considerations, distributions, and annual reporting. For example, as of this writing, the S&P 500 is currently up about 28% year-to-date, while investment-grade bonds (as measured by iShares US Aggregate Bond ETF (AGG), are up 3.2%. That differential in performance would cause a 60/40 stock/bond allocation to shift to a 65/35 allocation. To rebalance that portfolio back to 60/40, portfolio managers will need to reduce equity exposure by 5% and increase bond exposure by 5%.

(Click on image to enlarge)

Depending on the magnitude of the rebalancing process, it could exert downward pressure on risk assets, leading to a short-term market correction or consolidation.

The stock-to-bond ratio also demonstrates that risk.

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Historically, the stock/bond ratio remained between roughly 1:1 to 2.5:1. Today, that ratio has skyrocketed since the flood of liquidity following the pandemic as money chased risk assets over safety. At a ratio of 6.5:1, we suspect that, at some point, a reversion will take place. In the short term, given the outsized performance of stocks versus bonds in 2024, there is likely an unappreciated risk that portfolio rebalancing by managers could add a layer of selling pressure over the next couple of weeks.
 

Current Valuations Add To The Risk Profile

The second short-term risk remains valuations headed into 2025. While valuations are a terrible “market-timing” tool, they strongly indicate investor optimism. With consumer confidence in higher stock prices over the next 12 months to the highest level on record, it is unsurprising that valuations are pushing higher.

High valuations occur when stock prices exceed their intrinsic worth. Investors expect substantially more substantial earnings growth over the next 12 months to justify paying higher stock prices.

As noted in this past weekend’s #BullBearReport, earnings, according to S&P Global, are expected to grow by 19.87% in 2025 from $209.83 to $251.53 per share. This is well above the long-term earnings growth trend from 1900 to the present, and if estimates are accurate, earnings would rise above the peak-to-peak trend. The only time that happened previously was in 1998-1999.

Still, such exuberance is unsurprising during strongly trending bull markets, particularly when Wall Street needs to justify higher valuations. The problem is that such exuberant forecasts rarely come to fruition. For example, in March 2023, S&P Global predicted that 2024 earnings would grow by 13% for the year. In reality, earnings grew by just 9% despite the market rising nearly 28%. In other words, given that actual earnings fell well short of previous estimates, the 2024 market was driven largely by valuation expansion.

Current estimates for 2025 are well elevated above the running linear trend line from 2014, while actual earnings growth remains close to it. This suggests that we will likely see a decline in estimates for 2025 to roughly $225/share, equating to earnings growth of roughly 7%. Of course, the linear trend of earnings growth is a function of economic growth and an important consideration for investors betting on elevated returns in the New Year.

When sentiment and expectations exceed economic realities, such sets up the potential for a repricing of stocks. As such, stocks are priced higher relative to their earnings, indicating potential overvaluation. For instance, the S&P 500’s P/E ratio has reached levels that some analysts consider concerning, reflecting investor optimism that may not align with underlying economic fundamentals.
 

Expect Increased Volatility

While the bullish bias remains heading into year-end, combining high valuations and the need for portfolio rebalancing could lead to increased volatility. As noted above, if there is a more widespread need for rebalancing, it could apply downward pressure on stock prices. Furthermore, as the European Central Bank previously warned, high equity valuations and concentrated investments in major U.S. technology stocks pose risks to financial stability.

Historical data indicates that markets with elevated valuations are more susceptible to downturns. For example, during the dot-com bubble, excessive valuations led to a significant market correction. Similarly, the 2008 financial crisis was preceded by high valuations in the housing and stock markets. That correction resulted in substantial market declines. However, the problem is that market “exuberance” can generally last longer than logic would predict. Such is why we watch the annual rate of change in earnings as an indicator of future market direction. The annual rate of change in the market is pushing into more “rarified air,” only previously witnessed near more significant market peaks. If the annual rate of change in earnings begins to deteriorate, which we suspect it will in 2025, such would suggest a reversal in market growth rates.

Conclusion

As I consider the market in approaching our clients’ investment strategies, portfolio rebalancing is a near-term risk. It will undoubtedly increase portfolio volatility soon, but it is not a longer-term risk to be concerned about. However, with stocks significantly outperforming bonds in 2024, the imbalance in portfolios like the traditional 60/40 stock-to-bond allocation necessitates adjustments. Rebalancing, which involves selling equities and reallocating to bonds, could create downward pressure on stocks.

Valuations present a more serious challenge, given the interdependence between earnings and economic growth. While they are not reliable market-timing tools, elevated valuations reflect heightened investor optimism and expectations of robust earnings growth. Current earnings projections for 2025 suggest a nearly 20% increase, well above historical growth trends. However, we saw similar exuberance in 2023. The result was earnings falling short of estimates but a significant increase in asset prices. While such detachments of the market from earnings are not uncommon, they tend not to be sustainable over longer periods. We suspect that the risk to stocks in 2025 will be a failure of earnings to meet optimistic expectations.

While market sentiment may sustain markets in the short term, it leaves investors vulnerable to unexpected, exogenous events. Those “events,” when they occur, lead to sharp sentiment reversals. What would cause such a sentiment reversal? No one knows. That is why Wall Street’s immediate response is to suggest that “no one could have seen that coming.”

As such, investors must continue managing risk into 2025 and navigate the markets accordingly.

1. Tighten up stop-loss levels to current support levels for each position.
2. Hedge portfolios against major market declines.
3. Take profits in positions that have been big winners
4. Sell laggards and losers
5. Raise cash and rebalance portfolios to target weightings.

The trick to navigating markets in 2025 is not trying to “time” the market to sell precisely at the top. That is impossible. Successful long-term management is understanding when “enough is enough” and being willing to take profits and protect your gains. For many stocks currently, that is the situation we are in.

Manage risk accordingly.

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