A famed economist who called the 2008 recession warns stocks are in a ‘mega-bubble’ with the S&P 500 ahead of fundamentals by at least 25%

• Economist David Rosenberg warns the stock market is in a “mega-bubble.”
• Rosenberg cites high valuations, investor positioning, and sentiment as warning signs.
• Despite recent market gains, Rosenberg predicts a recession and advises caution in investing.

It’s a tempting time to jump into the stock market. The S&P 500 continues to register new highs and has climbed an incredible 23% so far this year. That’s on the heels of a 22% gain in 2023.

But now isn’t the time for greed, says famed economist David Rosenberg.

In notes to clients this month, the founder of Rosenberg Research, who called the 2008 recession, warned that the market is overvalued, eventually setting investors up to get burned.

“This is the mother of all momentum-driven stock markets,” he wrote in an October 9 note.

“When this mega-bubble pops, it will be spectacular,” he added on October 18. “This is no time to chase momentum or the herd mentality.”

Rosenberg said a large reason for his bearish outlook is a trifecta of measures sitting two standard deviations outside of average values: positioning in stocks, market valuations, and investor sentiment.

While he didn’t cite specific measures in his notes, many widely followed indicators corroborate these assertions.

For investor positioning, here’s household equity ownership as a percentage of assets as of the start of this year. North of 40%, it exceeds levels reached during the dot-com bubble.

For valuations, there are a myriad of different gauges, but two common ones to consider are the Shiller cyclically adjusted price-to-earnings ratio and the ratio of the Wilshire 500-to-GDP, shown below, respectively.

There are also many measures of investor sentiment. One popular indicator is the AAII Sentiment Survey. As of Thursday, 45.5% of its respondents characterized themselves as bullish, above the historical average of 37.5%. Almost half of respondents, however, said they think the market is overvalued.

By Rosenberg’s measure, the S&P 500 is at least 25% higher than where fundamentals suggest it should be.

“Prices have outpaced earnings growth in the past year and if this were a classic earnings-driven rally, the S&P 500 would be sitting near 4,600, not at 5,751,” Rosenberg said in the October 9 note. “Not only that, but analyst EPS revisions have been squarely to the downside.”

Since then, the S&P 500 has risen to 5,864.

Rosenberg’s bearish views on the market come alongside a pessimistic view of the economy. He said an expectation-beating September jobs report was an outlier in a downward trend, and he still expects a recession ahead.

Rosenberg’s views in context

The bearish economist has been calling for a recession for a couple of years now, and has warned at various points of an overvalued stock market.

Meanwhile, the market has soared, outperforming the expectations of even the most bullish strategists on Wall Street, and the economy has continually shown resilience despite interest-rate hikes.

But signs of weakness are emerging as the unemployment rate trends upward and job openings and new hires drop.

The Federal Reserve has started to take action to prevent further slowing by cutting interest rates by 50 basis points in September. But it’s still not clear whether the economy is at the start of a new business cycle, or whether it will buckle under the weight of elevated rates and plunge into recession.

Rosenberg thinks the latter scenario is more likely, and therefore cautioned investors about investing at this stage of the bull market, after such an aggressive rally over the last couple of years.

“Managing money means, at all times, preserving capital while capturing part of the upside,” Rosenberg wrote in the October 18 note. “J.P. Morgan reportedly once commented that he got wealthy not by buying at the lows and selling at the highs, but rather by being involved in the middle 60% of the bull market. We are well past that point.”