S&P 500: Correction Risks Rise but Year-End Rally Still in Play

The S&P 500 extended gains last week but is starting the week on negative note. Robust corporate earnings, rebounding U.S. growth, and anticipated Federal Reserve easing have been underpinning the rally. However, stretched valuations, inflation risks, and technical signals of overbought conditions suggest the probability of a short-term correction is rising. We maintain a constructive medium-term outlook, with potential for the index to reach 6,800 points by year-end.

Market Performance and Sentiment

The S&P 500 managed to eke out a small gain last week despite hotter-than-expected U.S. producer price index (PPI) data, which initially dampened expectations for a larger Federal Reserve rate cut in September. With the S&P 500 up almost 10% year-to-date and trading near its recent record highs, the outlook is increasingly defined by a delicate balance of optimism and caution.

Momentum remains strong, supported by robust corporate earnings and improved U.S. economic growth in the second quarter. Investor confidence is further reinforced by expectations of up to three Fed rate cuts this year given the rapid cooling of the labour market. We see such a policy path supporting the current rally into year-end.

Treasury Yields and Implications for Equities

Bond markets have also played a supportive role for equities as the 10-year U.S. Treasury yields have been on a gradual decline since late June. A break below support of 4.18% appears increasingly likely and could drive yields toward 4.00%. The 2-year yields have already breached their respective support, suggesting that rate expectations remain tilted toward easing. Declining yields are historically a bullish signal for equities.

Earnings Resilience Underpins Confidence

Earnings season has been another source of strength. Roughly 90% of S&P 500 companies have now reported June-quarter results, with 81% beating analyst expectations, according to FactSet. Standout performance in technology, utilities (fuelled by AI infrastructure demand), and housing-related sectors has added to the bullish backdrop.

Risks Lurking Beneath the Surface

Despite supportive fundamentals, several risks could challenge the S&P 500’s ascent. Valuations in some sectors are stretched relative to historical averages, raising the potential for sharper drawdowns in periods of volatility.

Inflation remains an important factor. While July’s CPI data was soft, the hotter PPI print highlighted ongoing price pressures, particularly in services. Any potential inflation resurgence in the coming months, stemming from Trump’s tariffs could force the Fed to cut less than currently anticipated and unsettle markets.

Additionally, technical indicators are flashing early warning signs. The index is overbought, and bearish divergences between price action and the Relative Strength Index (RSI) have emerged. As earnings season winds down, markets are approaching the seasonally weak months of September and October, increasing the probability of a short-term pullback.

Federal Reserve Policy in Focus

The Federal Reserve remains the most important driver for near-term sentiment. Traders now assign an 83% probability of a 25 basis points rate cut in September and expectations for a larger 50 basis point move have faded after the July PPI surprise. This leaves Fed Chair Jerome Powell’s speech at the Jackson Hole symposium as the key inflection point for rate cut expectations.

Source: TradingView

Medium- and Long-Term Outlook

While the probability of a near-term correction is rising, any pullback is likely to be healthy within the broader uptrend. Declining yields, resilient corporate earnings, and anticipated Fed easing create a constructive environment for equities over the medium term.

Options traders are piling into deep-out-of-the-money puts on the Nasdaq 100 ahead of Nvidia results and Powell’s Jackson Hole speech. The skew between deep and shallow puts is at a three-year high, showing traders are bracing for a selloff.

Such short-term selloff could reset valuations and improve conditions for the next leg higher. We expect U.S. markets to grind higher into year-end, albeit with more moderate returns compared to the past two years.

Our base case remains for the S&P 500 to potentially reach 6,800 points by year-end, supported by monetary easing, strong corporate performance, and ongoing investor demand for equities.

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