Stocks look dangerously overvalued and are at risk of a sharp correction as investors misjudge the sustainability of explosive earnings growth, DB says

A trader reacts during the opening bell at the New York Stock Exchange (NYSE) on February 28, 2020 at Wall Street in New York City.

  • US stocks are priced for near perfection, which could lead to disappointing returns for investors going forward, according to Deutsche Bank.
  • While earnings growth has been strong post-pandemic, there may be little room left for improvement, the bank said in a note on Thursday.
  • “With the current cycle advancing very quickly, the risk that the correction is hard is growing.”
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US stocks are priced for perfection following a robust year of post-pandemic earnings growth, but high valuations suggest a sharp market sell-off could be imminent, according to a Thursday note from Deutsche Bank.

On nearly every valuation metric, US stocks are trading at “historically extreme” levels, according to the bank. Trailing and forward price to earnings, enterprise value to EBITDA, and cash flow valuation metrics are well into the 90th percentile, Deutsche Bank highlighted.

Historical data shows that when valuations have gotten to such high levels in the past, five-year forward returns were on average negative. And with expectations high for continued strong earnings growth, investors could soon be let down as results potentially disappoint, the note said.

“We are skeptical the 85-year trend in earnings has changed,” Deutsche Bank said. The bank highlighted that analysts may soon be done playing catch-up in revising their earnings estimates to the upside.

“We look for earnings beats and upgrades to slow, diminishing if not ending what has been a key driver of equity upside, particularly year to date and supported multiples,” Deutsche Bank explained. The bank thinks confusion over where the market is in its current recovery cycle can explain a bulk of the recent gains, and is also one of the main risks going forward.

“At a fundamental level, we believe the key reason multiples are high is market confusion over where we are in the earnings cycle, in part reflecting the speed and surprise with which the economic recovery has unfolded and the large persistent beats this generated,” Deutsche Bank explained.

“So the cycle is much more advanced and the risk is that activity begins to slow, while the market is priced for most of the recovery as yet to come and large beats to continue,” the bank added. Weaker-than-expected economic data has slowly been materializing, most recently illustrated by the miss in August’s jobs report.

“With the current cycle advancing very quickly, the risk that the correction is hard is growing,” Deutsche Bank concluded.

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