Is the Market ‘Priced for Perfection’?

Photo: Oliver Quillia for CNBC.co

THE stock market has changed considerably since early 2000, when the Standard & Poor’s 500-stock index traded at a record high valuation.

Today, stocks are only about half as expensive, based on their price-to-earnings ratios.

And they’ve become a bit cheaper lately: the S.& P. 500 has fallen by more than 7 percent since Jan. 19. Yet in at least one important respect, there may be a significant parallel to the situation at the height of the tech bubble. Many market watchers say the late-January sell-off this year could be a sign that the market is again “priced for perfection,” said David C. Wright, managing director of Sierra Investment Management in Santa Monica, Calif.

“Investors have already priced in everything we can hope for in terms of an economic and profit recovery,” he said. Stocks rallied 65 percent from March 9 to Dec. 31 last year, and it may be unrealistic to expect that kind of advance now.

“Investors are expecting another Goldilocks scenario,” he said, adding that economically disappointing news is now likely to drive the markets lower in the coming months.

James W. Paulsen, chief investment strategist in Minneapolis, for Wells Capital Management, said that “when the market gets extended and optimism emerges, a sense of vulnerability develops.” In this case, the market was vulnerable to what Mr. Paulsen described as “government volatility.”

In the January sell-off, the big winners from last year, like emerging-market stocks and shares of blue-chip growth companies, tumbled the most. And the trouble in the markets began on the heels of several major policy announcements.

For starters, China’s central bank twice raised a benchmark short-term interest rate last month, aiming to slow the nation’s rapidly expanding economy and prevent the growth of a bubble in its financial markets. Although the rate increases were modest, they were widely seen as harbingers of a potential worldwide rate climb this year.

Investors had been banking on continuing stimulus plans throughout the year from governments around the globe, said Robert D. Arnott, chairman of the investment management firm Research Affiliates in Newport Beach, Calif. “But the question is A) how much more can governments do, and B) how much more should governments do?” he said.

The Obama administration announced plans last month for revamping banking regulations that, among other things, would rein in the size and growth of some financial institutions. The White House also signaled its intent, through its 2011 proposed budget, to let the Bush administration’s tax cuts for households earning more than $250,000 annually expire at the end of the year.

Jeffrey N. Kleintop, chief market strategist at LPL Financial in Boston, noted that there have been fears about the markets’ reaction once the era of global stimulus ends. “The jittery market movements reflect this trepidation,” he said.

Could this be the start of a bigger sell-off?

Quite possibly. Since the bull market began last March, the S.& P. 500 has not experienced a correction of at least 10 percent, even though pullbacks of that magnitude have historically occurred nearly once a year, according to Ned Davis Research, an investment-consulting firm in Venice, Fla.

But Mr. Paulsen says he does not believe that worries over shifting government policies will kill this bull.

“I don’t think this is enough to start a bear market,” he said. “I’d be much more concerned if the factors that caused the sell-off were caused by a drop off in the fundamentals.”

SO far, that has not been the case.

Indeed, around 80 percent of companies in the S.& P. 500 have beaten analysts’ consensus forecasts for profits in the fourth quarter, and more than two-thirds have exceeded expectations for revenue.

Some strategists say the market is overlooking this good news. “I was surprised that investors looked past pretty favorable economic and earnings data to focus on the Washington headlines,” said Jack A. Ablin, chief investment officer at Harris Private Bank in Chicago.

But then again, Mr. Ablin said, he was not surprised by the recent pullback because “the market was — and probably still is — fairly to fully priced.”