Here are 5 things that could derail the S&P 500 from record highs, according to LPL Financial

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Here are 5 things that could derail the S&P 500 from record highs, according to LPL Financial
Traders work on the floor of the New York Stock Exchange. Brendan McDermid/Reuters
  • The S&P 500 charged up 6.9% in October but a few things could spook markets into year-end, said LPL Financial.
  • Sticky inflation and pressure on corporate America's profit margins could hurt the broad-market gauge.
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The S&P 500 index finished October with its best monthly gain of the year but stubborn inflation and a strong attack by the Federal Reserve against elevated price pressures are among five factors that "might spook markets" in the near-term, according to advisory firm LPL Financial.

The benchmark index closed up 6.9% in October and has hovered near record highs, with the index largely bolstered by corporate financial reports that are beating analyst expectations for the third quarter. More than half of S&P 500 companies have reported and 82% of them have surpassed Wall Street's earnings targets, according to FactSet. The S&P 500 has jumped about 22% so far this year.

"If our positive near-term market outlook proves to be overly optimistic, we believe one -- or perhaps more than one -- of these five things will likely be the culprit: inflation, an aggressive Federal Reserve, profit margin pressures, pulling forward of seasonal gains, and potentially overly bullish sentiment," said Ryan Detrick, chief market strategist at LPL Financial, in a Monday note ahead of the Fed's two-day policy meeting.

Here are the five factors LPL says pose a risk to the record-setting stock market.

1) Inflation

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Consumer and wholesale price inflation have climbed to multi-year highs in 2021 and central bank policy makers are "slowly acknowledging" that inflation may be stickier than expected.

"While inflation has come down some recently, we believe there may be another leg higher in the fourth quarter or early next year as the post-surge reopening pushes prices higher in areas where it had paused or declined as economic activity slowed, such as air fares, lodging, and used cars," wrote Detrick.

How long it will take supply-chain disruptions to reverse course is the "wild card" for inflation as they have been a key source of imbalances between supply and demand that have propelled prices upward, he said.

2) An aggressive Fed

The US central bank is widely expected on Wednesday to signal or say it will begin to wind down the $120 billion a month it purchases in Treasuries and mortgage securities. It started the monthly buying in March 2020 in response to the then-unfolding COVID-19 crisis. The Fed is expected to end bond purchases by the middle of 2022 and then begin raising interest rates, which LPL foresees starting in early 2023.

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"However, if inflation is stickier than we are anticipating and the Fed is forced to aggressively respond early next year -- first by potentially speeding up its tapering plans, and then by increasing short-term interest rates -- economic growth will likely be negatively impacted," and that could rattle investors, Detrick said.

3) Profit margin pressure

"Companies have generally done an excellent job managing through supply chain disruptions, labor and materials shortages, and related cost pressures," but there are reasons for concern, he said.

Corporate profit margins are above their pre-pandemic highs and carry downside risk. The US labor shortage has prompted employers to offer higher pay to attract workers, leading to wage growth in September surging to 4.6% year over year. As well, companies are dealing with shortages of materials that push prices up for manufacturers.

"These pressures on companies' costs could impair profit margins if they continue to build," said Detrick. "For now, strong revenue growth is overshadowing these margin pressures but with stock valuations elevated, it's important that earnings come through or markets may get spooked."

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4) Seasonal gains may have come early

The S&P 500 was entering November with a hefty advance made last month.

"But that's the problem: October very well could have stolen some of the gains we usually see later in the year," said Detrick. The S&P 500 has historically risen 3.3%, on average, the final two months of the year. But when the index is up more than 5% in October, that average gain falls to 2.1% with a median of only 1.1%.

"After the year we've had, we don't think anyone would have any issue with only modest additional upside through year-end, but we'd temper expectations on just how much green we could have the final two months."

5) Bullish Sentiment

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LPL Financial said it sees a bullish technical setup for equities in the final months of 2021 but if there is a technical risk to watch, it is likely sentiment. The percent of bulls in the American Association of Individual Investors Investor Sentiment Survey more than doubled from its mid-September lows. Meanwhile, the CBOE Volatility index, or the VIX measure of implied volatility in the S&P 500, is near its lowest level since before the pandemic began.

"Overall, we do not see evidence that sentiment is near extreme levels yet, or that the technical trends do not support a bullish view. But if the next few months do bring equity gains, sentiment may become a bigger risk," Detrick said.

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