'Signs of excess are building': 4 Wall Street giants explain why the stock market's rally may have gone too far - and share their advice for what happens next

• The stock market's record-setting rally has unnerved some Wall Street strategists.
• They're concerned about the slower pace of profit growth, as well as lingering risks.
• The views of four major Wall Street firms on the market's rally, and what they recommend investors do next, are summarized below.
• Click here for more BI Prime stories.

The stock market's record-setting advance that gained steam late last year now has multiple Wall Street experts worried.

At issue for many of them is that the rally has run far ahead of profit growth and lifted the ratios of stock prices to profits to levels rarely seen during this bull-market run. A composite gauge of 34 valuation metrics compiled by RBC Capital Markets recently broke through its highest level of this nine-year bull market.

With the fourth-quarter earnings season underway, investors will be watching closely for the guidance companies provide on their profitability this year.

Meanwhile, some strategists say traders who have made outsized bets for continued gains could be penalized if the market is pulled lower by risks like a potential conflict between the US and Iran.

The views of four major Wall Street firms on the market's rally, and what they recommend investors do next, are summarized below.

1. JPMorgan: 'Signs of excess are building'

This so-called excess is not exclusive to stocks: Investor positioning across major asset classes including equities and fixed income is at levels associated with market corrections, according to John Normand, the head of cross-asset fundamental strategy at JPMorgan.

Additionally, he sees multiple risks that could stop the rally in its tracks, including a progressive Democrat like Sen. Bernie Sanders gaining traction in the primaries, a slowdown in the Fed's balance sheet expansion, and the US-Iran conflict.

"Given early signs of excess in global markets, any of these spoilers could justify at least a warning about drawdown and possibly a material change in portfolio allocation or hedges," Normand said in a note on Friday.

Recommendation: "We are already positioned for two of these potential stress events - for the Democratic primaries via underweights of US vs non-Equities and shorts in the dollar; and oil supply stress via broad overweights of Energy across Equities & FICC."

2. Goldman Sachs: 'Lackluster' 4Q earnings should be a turning point

David Kostin, Goldman Sach's chief US equity strategist, expects fourth-quarter earnings to be lackluster after three preceding periods of declines last year. Notably, profit margins are expected to shrink across all sectors for only the fourth time since 1990, he said.

However, the fourth quarter should represent a turning point as investors shift their focus to 2020, Kostin said. He forecasts 6% earnings-per-share growth for the full year and sees this upturn driving the S&P 500 to 3,400 by year-end.

"Investors should focus on the commentary provided by managements on earnings calls to understand the extent to which political uncertainty is likely to affect corporate decision making," Kostin said in a note on Friday.

Recommendation: Cyclical stocks could rally alongside an acceleration in economic growth, which Goldman's economists expect. Kostin recommends an overweight on the industrial sector, which should benefit from this upswing.

3. Bank of America: Watch out for 'tactical risks' heading into February

While there are "plenty of reasons" to be bullish on stocks in 2020, risks abound for the nearer term, according to Stephen Suttmeier, the chief equity technical strategist at Bank of America.

For starters, February is a seasonally weaker month for the S&P 500. Since 1928, the index has averaged a 3.3% gain from November through January but -0.02% in February. This means the rally may pause after a three-month stretch that has delivered above-average gains.

But beyond the calendar effect, a few technical trends stand out to Suttmeier. These include the put-call ratio, which compares traders' bets for higher prices to their wagers for lower prices. At 0.53, the ratio is at its lowest and "most complacent" level since 2012, Suttmeier said, meaning that bullish bets disproportionately outnumber bearish ones.

Recommendation: "Don't fight the Fed: A down January has not consistently preceded a down year since the Great Recession," Suttmeier said in a note on Tuesday.

4. Societe Generale: Stocks have an 'incredible valuation problem.'

Andrew Lapthorne, the French bank's head of quantitative equity research, pointed out that while stock prices have climbed, earnings growth has been in decline since the first quarter of 2019.

Meanwhile, the ratio of stock prices to earnings forecasted 12 months from now has spiked to its highest level since 2002, according to Bloomberg data.

Lapthorne further crunched the numbers by isolating growth stocks, or companies where investors have the greatest expectations for profits. The PE ratio for this cohort has jumped to levels only seen during eight months of a three-decade span, he found.

Lapthorne attributed the divergence in stock prices and earnings growth to central banks, which continue to inject liquidity in markets and maintain an accommodative policy stance.

The mismatch is not only evident in US stocks: the average MSCI World Index stock has gained 26% over the past year, yet the average change in forward earnings-per-share expectations is 1.5%, Lapthorne said in a recent note.

Recommendation: Buy quality small-cap stocks via the MSCI USA Select Strong Balance Sheet Index. If earnings do not improve, investors may punish the smallest companies with the weakest balance sheets the hardest.