SAN FRANCISCO (MarketWatch) -- The bears are warning: A herd mentality on Wall Street is driving stocks to unsustainable levels.
As an extended rally prompts some strategists to raise their price targets for the year, the pessimistic ones are arguing that those prices are being supported more by performance-chasing investors than by any real improvement in fundamentals.
"My experience is when managers are overly focused on performance on a near-term basis, and worried they're missing out, it means they're buying stocks for the wrong reasons," said Brian Belski, chief investment strategist at BMO Capital Markets.
He's sticking to his 1,575 target for the Standard & Poor's 500-stock index this year, even though the benchmark is trading nearly 5% above that target, closing Friday at 1,649.60.
Stocks are in uncharted territory when it comes to the Dow Jones Industrial Average (DJI) and the S&P 500 (SPX), and this past week they faced the first real resistance since they started setting new highs in late March.
Four weeks of steady gains ground to a halt after Federal Reserve Chairman Ben Bernanke, in his answers to lawmakers' questions, mentioned that bond purchases could be tapered in the next few Fed meetings.
Since the S&P started setting new closing records in late March, the index has climbed 6.6% in less than two months to its new closing high of 1,669.16, set Tuesday.
During that time, stocks have appeared impervious to bad news -- only taking an appreciable pause during the week of the Boston bombings -- with the Dow industrials or the S&P 500 or both closing at all-time highs on practically a daily basis.
Much of that recent strength has come out of a resurgence in cyclical stocks over defensive stocks. While sectors such as health care and consumer staples have been big outperformers all year, May has brought an advance in industrial and energy stocks along with a selloff in utilities and telecom stocks. To stock watchers who like to see cyclicals lead when stocks rise, that's another sign of strength.
Recently, some firms have taken the rally as an opportunity to hike their S&P 500 targets for the year. Goldman Sachs raised its target for the second time this year to 1,750 from 1,625 and a previous 1,575, citing improved economic growth and potentially low interest rates. J.P. Morgan Chase analysts raised their target to 1,715 from 1,580, noting that the average gain in the fifth year of a bull market is 19%.
More circumspect strategists, however, believe that prices are playing too big a role in dictating higher valuations and elevated targets.
A big jump in optimism when there's a lack of new positive developments is a cause for concern, said Gina Martin Adams, institutional equity strategist at Wells Fargo Securities. That supports the view that institutional investors are chasing performance in the equity markets.
She's also sticking to a price target -- 1,390 for the S&P 500 by year-end -- that's well below current levels.
"Virtually no one is expecting a major correction in equities," Adams said. "As you get more optimism, the chance of a correction increases."
The rise in stock prices is not changing her target because her model, based on earnings and other economic indexes, including the Chicago Fed's national activity index, is suggesting multiple contractions into the end of the year.
And results this past quarter were not much to write home about. Adams noted that if you strip financial-sector revenues from the S&P 500, what results is a decline of 0.8%. Add to that 46% of companies missing consensus revenue estimates, compared with the long-term average of 27%, and the picture looks more at home in a recessionary economy than an improving one, according to Adams.
Limitations in earnings, plus a so-so macroeconomic picture, also color Belski's view of future stock gains. The BMO strategist said the macroeconomic picture is not great even with some small improvements in jobs and housing, while earnings -- the biggest driver of stocks -- are not growing at a pace that would justify prices. "We're not knocking the cover off the ball in terms of earnings," Belski said.
With valuations in the ballpark of 15 times earnings, Belski doesn't see substantial market gains from here without substantial earnings and dividend growth from U.S. companies, he said. In the first quarter, earnings grew about 3%, while revenue declined 0.3%, according to FactSet.
Even so, that bit of overstretch may be good for overall market health as pullbacks weed out marginal buyers and investors who are chasing the market, he said.
This week's volatile moves are also a mark against the rally.
Mark Arbeter, chief technical strategist at S&P Capital IQ, said that Wednesday's "ugly reversal" may be the start of a topping process for the S&P 500. With the S&P 500 overbought from a daily, weekly and monthly perspective, Arbeter said that intermediate-term tops take time to play out.
"One key for an intermediate-term top is a dramatic pickup in price volatility, both on the upside and the downside," he wrote in emailed comments.
While it finished Friday slightly down, the CBOE Volatility Index (VIX) rose 12% to close out the week at 13.99 but is still off 22% for the year. With a few exceptions, that level for the VIX is more reflective of the stock market from 2004 to 2007 than at any time since.
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(END) Dow Jones Newswires
May 24, 2013 20:06 ET (00:06 GMT)