S&P 500 Outlook: Valuations, Real Yields, and the AI Hype

S&P 500, as we all have been saying too many times, is moving mostly because of a small group of very large tech companies (something Big - big seven ). S&P 500 gives more weight to Nvidia, Microsoft, Apple, Amazon, Alphabet, and Meta etc. you know them by heart now, and have quite an impact on how the market performs each day. This pushed index higher during the rally, but it also means the market could fall faster if these few leaders start to weaken (big problem for little guys like us traders).

One way to see this is by looking at the equal-weight S&P 500, where every company counts the same, it will show that many stocks are not doing as well as the headlines imply. When only a handful of stocks are driving gains, it often happens late in a rally and can signal greater risk if momentum fades.

Many of the biggest companies in the index are priced higher than cautious estimates of what they are truly worth. The main concern is how much their prices depend on interest rates. Growth stocks are especially affected because most of their expected profits are far in the future (that may not come). Investors estimate the value of future profits today by "discounting" them back to the present using the interest rate.

Present Value (PV): what the company is worth today

Future Cash Flow (CFₜ): money the company is expected to make in the future

Discount rate (r): influenced heavily by interest rates and bond yields

When interest rates stay high, that discount rate is higher. Because it is applied over many years, it reduces today’s value a lot for companies whose profits are expected far in the future. That is why highly valued technology and growth stocks tend to be more sensitive when interest rates remain elevated.

Inflation and Real Yields

Inflation has come down from its highs, but real interest rates, which are interest rates after subtracting inflation. If inflation keeps falling but central banks leave interest rates high, real rates go up. Higher real rates tend to make borrowing and investing conditions tighter, bonds and cash more attractive compared to stocks and push stock valuations lower.

Because of this, lower inflation by itself does not guarantee that stocks will do well. Stock markets often have more trouble when real interest rates are high than when inflation is simply elevated.

Earnings Expectations vs Economic Reality

Today’s stock market levels assume that company profits will keep growing. Forecasts are based on the idea that demand will stay steady, profit margins will hold up, and new technologies will help companies become more productive.

But profit margins can be pressured by rising wages, higher borrowing costs, and changes in how consumers spend. If the economy slows down, earnings forecasts may turn out to be too optimistic. With stock prices already high, there is less room for companies to miss expectations without share prices falling.

Jobs remain relatively strong, but unfortunately unemployment tends to react slowly, rising only after the economy has already weakened. Sahm Rule flags recession risk when unemployment jumps sharply from recent lows. Right now, it isn’t signaling danger, but even a small weakening in the labor market could hurt company revenues and shake investor confidence.

Large tech companies, which drive the index's growth, also pose structural risks. Much of the growth is driven by a few companies, and poor performance by just one or two of these leaders can drag the entire index down, while other sectors contribute less.

When a market is driven by only a small group of companies late in the cycle, it becomes more vulnerable to regulatory changes or interest rate movements.

Today market faces several risks