What Could Spook Markets

Scare #1: Late Cycle Economy

Even though we do not have all the official government data on the labor market, it’s no surprise that the U.S. labor market appears to be approaching stall speed. What’s concerning is the potential that the labor market goes one step further in the wrong direction and cuts jobs. Now it’s nearing stall speed, a condition where job growth slows to a level insufficient to keep pace with population growth, which does raise recession risks. Historically, hiring slowdowns have been among the earliest indicators of economic downturns because employment drives consumer spending, which accounts for nearly 70% of GDP. When businesses curb hiring, household income growth stalls, confidence erodes, and spending contracts, creating a feedback loop that can deepen economic weakness. Past episodes, such as the 2001 and 2008 recessions, showed that sustained declines in job creation often preceded broader contractions in output and investment. The latest official data released prior to the government shutdown suggests the labor market is losing momentum, even as unemployment edges higher from historic lows. Private data such as the ADP report showed further slowing. If hiring remains subdued, unemployment could climb, triggering a vicious cycle of reduced consumption and further layoffs. This dynamic underscores why policymakers, including the Federal Reserve (Fed), view labor market health as critical to sustaining economic growth and have signaled further rate cuts to counteract these risks.

Scare #2: Stock Valuations Are Near Late-1990s Dotcom Boom Peak

There’s been a lot of bubble talk recently, given the strong gains in artificial intelligence (AI) stocks and expansion and concentration of the technology sector — at an all-time-high ~35% weighting in the S&P 500. Coupled with rallies in momentum stocks and unprofitable companies, many have drawn comparisons between this market environment and the dotcom boom of the late 1990s. We’ll save that debate for future publication. Using a basic valuation approach with the price-to-earnings ratio (P/E) for the S&P 500 on a trailing four-quarter basis, we find that the index currently trades at a P/E of 28, very close to the 1990s dotcom peak around 30 and well above the respective 10-, 20-, and 40-year averages of 21.1, 18.4, and 18.3. Perhaps most concerning about the high P/E is that it may augur very modest long-term returns. We wrote about this concept around this time last year in an LPL Research blog post. While valuations are not good short-term market timing tools, they have historically been good predictors of long-term stock returns. This relationship points to low single-digit total returns for stocks through 2035 — a scary proposition if that’s all we get. One counterargument is that we’ve entered a new regime of productivity thanks to AI that may drive structural improvements in corporate profitability. Higher returns on invested capital from technological advancements could enable stocks to outperform this relationship, although anything better than mid-single-digit annualized returns over the next 10 years would surprise us.