We've certainly seen that over the past two months. Despite worry over mounting U.S. debt and tariff impacts on inflation and the economy, the S&P 500 has rallied 20%. Technology stocks have done even better. The Nasdaq Composite, home to most tech leaders, is up 27%.
The rally since President Trump paused most reciprocal tariffs announced on April 2, so-called "Liberation Day," for 90 days has been impressive.
However, there's good reason for concern, especially since the S&P 500 is challenging all-time highs and its valuation is arguably becoming frothy again.
The risk that stocks could lose some of their luster after their rally has caught the attention of many Wall Street veterans, including long-time hedge fund manager Doug Kass.
Kass has been navigating the markets since the 1970s, including as research director for Leon Cooperman's Omega Advisors, and his experience through good and bad times helped him correctly predict the sell-off earlier this year and the market bottom in April.
This week, Kass updated his stock market outlook, including a surprisingly long list of red flags for why investors should be cautious.
Doug Kass expects stocks to give back some of their recent gains.Image source: TheStreet
Stocks have become richly valued (again)
The best set-up for tantalizing returns is a market that's oversold enough to have reset forward price-to-earnings ratios to levels near the lower end of their historical averages.
In February, when stocks were notching all-time highs right before the tariff-fueled reckoning, the S&P 500's P/E ratio eclipsed 22, and most sentiment measures were flashing overbought.
The sell-off through early April erased much of that frothiness, driving the S&P 500's P/E ratio to 19 and below five-year averages of 19.9 — not bargain-basement priced, but low enough to help catapult stocks from severely oversold readings. As a reminder, CNN's Fear & Greed indicator was at "Extreme Fear," and bearishness by most measures was sky high in the days after the April 2 tariff announcement.
Now that the stock market is back near its highs, sentiment has turned optimistic again, with CNN's measure flashing "Greed." Because earnings forecasts haven't materially increased, the S&P 500's P/E ratio is north of 21 — hardly cheap.
The S&P 500 forward price to earnings ratio is 21.6 on June 15, according to FactSet.Image source: TheStreet
"Valuation multiples expanded in a relief rally from mid-April to now and the S&P 500 now trades at 21x forward earnings, 35% above average," wrote Bank of America analysts to clients on June 14. "The index looks statistically expensive relative to its own history on all 20 of the valuation metrics we track."
Hedge fund manager spotlights reasons stocks could drop
Doug Kass has tracked the market successfully through 1970s skyrocketing inflation, 1980s double-digit interest rates, the Savings & Loan crisis, the Internet boom and bust, the Great Recession, a pandemic, and the bear market of 2022.
He's seen a lot over his nearly 50-year career, making his stock market warning now worth paying attention to.
"Equities haven't been this unattractive since late 2021," wrote Kass on TheStreet Pro. "There is little room for disappointment.
The concern that stocks have priced in much of the good news likely to come from ongoing trade negotiations may have merit, given this week's China trade deal news left tariffs at current levels near 55%. As the impact of tariffs flows through supply chains, inflation may start rising within months, crimping household and business spending.
Unfortunately, that's not the only risk on Kass's mind. The money manager provided a long list of threats that could derail stocks' rally.
It's a long list, so you may want to refill your beverage. He writes:
Political and geopolitical polarization and competition will probably translate into less political centrism and a reduced concern for deficits, creating structural uncertainties, limited fiscal discipline, and imprudence around the globe ... and for the possibility of bond markets to "disanchor."
The cracks in the foundation of the bull market are multiple and are deepening, but they are being ignored (as market structure changes have led to price momentum [fear of missing out] being favored over value and common sense).
With the S&P 500 Index at around 6000, the downside risk dwarfs the upside reward for equities — in a ratio of about 5-1 (negative).
Valuations (a 22-times forward Price Earnings Ratio) and (consensus) expectations for economic and corporate profit growth are all inflated.
Being dismissed are JPMorgan CEO Jamie Dimon's and others’ dour comments on complacency and a view that the corporate credit market is "ridiculously over-stretched.”
Look for the soft data (see last week's weak ISM and climb in jobless claims) to move into (and weaken) the hard data led by a slowing housing market likely to provide ample near-term evidence of the exposure and vulnerability of the middle class.
Below trend-line economic growth (housing will lead us lower) coupled with sticky inflation lie ahead ("slugflation") — uncomfortable for a Federal Reserve which has to make increasingly more difficult decisions.
Corporate profit growth (rising +13% in 1Q2025) will markedly decelerate in this year’s second half.
The equity risk premium is at a two-decade low — typically consistent with a slide in equities.
The S&P Dividend Yield is at a near-record low of 1.27% — and the spread between the dividend yield and the 10-year U.S. Treasury note yield has rarely been as wide. With so many possible adverse outcomes, my baseline expectation is for seven lean months ahead over the balance of 2025.
Kass is clearly nervous that any single or combination of headwinds could cause stocks to give back some gains.
What should investors do? Over time, the stock market goes up and to the right, so those with long-term horizons are often best off sticking to their plan, recognizing that there will be bumps and bruises along the way.
However, investors with a shorter-term horizon may want to rein in some risk, pocket some profit, and increase "dry powder" to take advantage of any weakness if Kass's warning proves prescient.
