The American stock market has gone from ice cold to red hot.
In just five weeks, the S&P 500 is up an incredible 13% from the February 11 lows. That rally has lifted the stock market into positive territory in 2016. Considering the market had its worst start to a year on record, it’s an impressive feat.
The turnaround was fueled by a combination of powerful forces: Oil prices stopped its downward spiral and started soaring; overblown U.S. recession fears faded and the Federal Reserve is tapping the brakes on its plans in increase interest rates.
But the speed of this rebound has some scratching their heads. After all, the backdrop of sluggish global growth hasn’t changed. The sharp rise is due for a pause and could even be followed by a pullback. Skeptics point to a number of potential yellow flags, including soaring valuations and vanishing volatility.
“Too much of a good thing can sometimes come with a downside,” Russ Koesterich, chief investment strategist at BlackRock, wrote in a recent note.
Koesterich pointed to the dramatic decline in market turbulence. The VIX volatility index is now sitting at just 14, the lowest level since August and down by more than half in the past month.
“The stage could be set for a return of volatility and another selloff,” he wrote.
Markets at risk of ‘melt-up’ scenario
Another obstacle could be the suddenly-lofty price tag investors are assigning to the stock market. The S&P 500’s forward price-to-earnings ratio rose to 16.5 on Friday, up from just 14.7 on February 11, according to Yardeni Research. Valuation multiples on small and mid-cap stocks are even higher.
“Any further advance in stock prices would increasingly push the market into melt-up territory,” Ed Yardeni, president of Yardeni Research, wrote in a client note.
“Melt-ups” in the stock market subject to reversals because they aren’t supported by strong fundamentals.
David Kelly, chief global strategist at JPMorgan Asset Management, thinks stocks “look closer to fair value rather than cheap.”
Oil, economy fuel rebound
On February 11, the Dow fell as low as 15,503. Back then investors were freaking out over the crash in oil to $26 a barrel, fearing it signaled a global recession. Oil prices have ripped higher since then, climbing to nearly $42 a barrel on Monday.
It’s also become clear the U.S. economy is weathering the global storm. The economy may not be booming, but there are few signs of an imminent recession that would justify a market plunge.
Worries the Fed is raising rates too quickly have also receded. Last week the Fed dialed back its 2016 rate-hike plans to two moves, down from four. That has helped cool off the U.S. dollar, which is down more than 3% against rival currencies this year. The dollar’s recent strength hurt corporate profits by making products sold overseas more expensive.
Key test: earnings season
Still, some think the pendulum may have once again swung too hard, this time in favor of risky assets like stocks.
Peter Boockvar, chief market analyst at The Lindsey Group, points to a momentum gauge known as the relative-strength index. The S&P 500’s seven-day RSI is above 80 for the first time since November 2014. Boockvar cites this as evidence the market is “overbought” and the rebound is just a bear market rally.
Even market bulls think a timeout could be a good thing.
“Investors should not be surprised if the market pauses sooner than later,” John Stoltzfus, chief investment strategist at Oppenheimer Asset Management, wrote in a report.
The real test will come the week of April 11, when earnings season kicks off with key reports from Alcoa, Wells Fargo and others. Since valuations have little room to improve further, real improvement in earnings will be needed to justify the market rally.