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If you think the market has gotten ahead of fundamentals, you’re not alone.

That’s what Michael Kantrowitz, chief investment strategist at Cornerstone Macro, said. Barrons Tuesday, a day after the S&P 500 erased its loss for the year and the Nasdaq Composite closed at a record high. The question he asks clients the most these days: how do you interpret these substantial gains in the face of improving, but still very weak economic and corporate earnings data?

Markets are looking to the future, of course, and there’s an obvious explanation for a stock market that has soared – the S&P 500 is up 10% over the past month – even though data shows that it will take some time for the economy to get anywhere near pre-virus levels. Extraordinary monetary and fiscal stimulus filled a huge revenue hole, and Federal Reserve Chairman Powell assured investors he was willing and ready to do more. This happened as recently as Monday, when the Fed expanded its Main Street lending program, making it easier for small businesses to get loans.

But that answer isn’t enough to satisfy many investors who are increasingly concerned about the disconnect. “It may work for a short time,” Kantrowitz said, referring to aggressive stimulus measures. But at some point, the fundamentals will matter. He points out that the S&P 500 is trading at about 22 times forward earnings, last seen during the tech stock bubble era. The market has fully rebounded to pre-virus levels in two months, while the data we’ve seen so far suggests it will take at least two years for the underlying economy to follow suit. After all, there are around 20 million people out of work and the layoffs, while slowing, continue.

The current market is in line with data we saw in 2019, which reflected a relatively strong economy, Kantrowtiz says. “Over the past few months, and for the first time in the data, stocks are far from fundamental,” he says. “It smacks of irrational exuberance a bit.”

Behind Cornerstone’s analysis is its own leading indicator, something Kantrowitz created years ago by combining economic measures such as the ISM manufacturing index, consumer and business confidence surveys and data. in the housing market. Stocks tend to trade with its leading indicator, not behind it as the name suggests, and the correlation between the Kantrowitz Gauge and the S&P 500 over the past 13 years has been 90%. Now that correlation is out the window.

What he’s saying is we’ve pulled forward all the gains we’ll see during the rally, which means that for stock market gains to continue, the current price-to-earnings ratio must rise, Kantrowitz says . That could certainly happen thanks to ongoing stimulus measures (he notes that the S&P 500 PE peaked at around 25 in 2000), or corporate earnings could rebound faster than Wall Street predicted. All of that is possible, but not likely, he says, especially given that current Wall Street expectations translate to a 100% rebound in earnings for 2021.

Kantrowitz’s best guess is that the market goes sideways for a long time as a recovering economy catches up. It is also to say that it does not predict an imminent decline. The recovery is underway, with the best evidence of this in the form of an unexpected increase in nonfarm payrolls for May. But it’s not about whether a recovery has started. It’s a matter of how quickly the US economy gets back to normal, and it will be a slow process.

The question investors should be asking now, Kantrowitz says, is that six months from now it will seem fair to have forecast a full recovery. How can those who are likely to see it like him, that the market is currently overvalued, play?

The cornerstone is the overweighting of cyclical sectors with those considered to have the best fundamentals. In particular, Cornerstone likes industrials, which has been the best performing sector over the past month, and consumer discretionary stocks. Cornerstone is also overweight the technology and communications sectors, thanks to what Kantrowitz says is a trio of top earnings, cash flow and balance sheets.

And as value stocks return to center stage, Kantrowitz notes that the historical correlation between his leading indicator and the S&P 500 Value Index has been even higher – 94% – than the correlation with the larger index. large. This is potentially a problem. “If you believe the story that the market is way ahead of itself,” he says, “then value stocks are even more risky.”

Write to Lisa Beilfuss at [email protected]