Investors need to dial back risk-taking as stock valuations are being driven by euphoria, not fundamentals, research firm says

• Stock valuations are being driven by investor euphoria, Rosenberg Research says.
• The firm says such stretched valuations are cause for concern, as they're not supported by fundamentals.
• The firm points to several indicators nearing levels last seen in 2021, which was followed by bear market in 2022.

Investors should dial back risk heading into the new year as stock valuations are being supported mainly by euphoric sentiment, Rosenberg Research said this week.

The firm's Marius Jongstra said current stock valuations aren't supported by fundamentals. At such high prices, and with policy uncertainty looming ahead of president-elect Donald Trump's second term, it's not the time to chase risk, Jongstra says.

"Now is not the time to be blindly chasing equity risk higher, especially with so much policy uncertainty still lingering next year. Dial back risk and be selective in exposure instead," Jongstra wrote in a Monday note.

It's not the first time the firm has sounded the alarm on stretched valuations, but now several indicators appear to be approaching levels last seen in 2021, which was followed by a brutal bear market decline of 25% in 2022, Jongstra said.

He pointed to the firm's "bubble indicator," a metric including measures of valuations, margin debt, cash ratios, and sentiment, acting as a gauge of investor exuberance and overconfidence.

Since recent lows toward the end of 2022, the indicator has risen steadily, hitting a reading of 1.29 in November. That's just short of a recent peak in 2021 of 1.33, though both are still below an-all time high of 1.72 reached in 2000.

Meanwhile, the Shiller CAPE ratio, a measure of valuations that normalizes stock market prices to earnings over a trailing 10-year period, is similarly approaching highs last seen in 2021.

The current reading of 38.1x "normalized" earnings for the S&P 500 is just short of the 38.3x recent high from December 2021, showing similarly stretched valuations.

If that reading crosses above 40x, a rare event that's only happened 2% of the time historically, it could be a sign that overvaluations will be a threat to forward returns. When the indicator has crossed that threshold previously, the S&P 500 average one-year, five-year and 10-year returns have turned negative, posing around 3% annual losses, Jongstra's data shows.

"Momentum is a powerful force and can carry markets much higher than people think. But when investors feel overconfident about the future and are willing to chase stocks higher, utilizing a larger degree of leverage to juice returns while pushing valuations to lofty levels, then risks to longer-term returns are heightened," Jongstra wrote.

Other analysts have similarly sounded the alarm on stretched valuations in recent months, including JPMorgan Asset Management's David Kelly and Stifel's Barry Bannister.

Some, though, have said such high valuations are justified.

In a note earlier this month, analysts at UBS said the rising share of tech companies in the S&P 500 means high valuations make sense, given those firms have grown their top lines quicker and with higher margins than non-tech stocks.