The world looks a lot more dangerous than it did only a few months ago and signs are that U.S. stock investors are starting to demand more for the added risk.
With important manufacturing and jobs data due this week, it could start to get even riskier.
That means nervous investors are likely to keep a lid on equity prices this year as they grapple with slowing global growth and a host of geopolitical risks from the Arab Spring to debt defaults in the euro zone.
The actions of some big Wall Street banks best show the shift in the risk-reward nexus. Over the last two weeks, UBS, Citigroup and Goldman Sachs have effectively lowered their view of what investors will be willing to pay for a dollar of corporate earnings this year.
Jonathan Golub, chief U.S. equity strategist at UBS in New York, made the decision to keep his S&P 500 Index target on hold, even though he increased his expectations of what S&P 500 companies would likely earn this year and next.
"Earnings are going to continue to surprise to the upside, but investors will continue to be reluctant to believe in the sustainability of earnings and, therefore, not give full credit to that," Golub said.
Golub raised his average S&P 500 earnings estimate to $101 from $96 for this year, but left his year-end S&P 500 target at 1,425. By doing that, Golub has effectively lowered his price-to-earnings (P/E) ratio — the amount investors are willing to pay for a dollar of earnings — to 14.1 from 14.8.
That amounts to an increase in the expected equity yield — a measure of the return investors want — to 7.1 percent from 6.8 percent.
That is significant because the expected price-to-earnings ratio was already below what investors have historically been willing to pay for S&P 500 earnings. The average trailing P/E ratio is 15.6 over the last five years and 19.2 since 1988, according to Standard & Poor's.
Golub argues that a batch of weak economic data pointing to slowing manufacturing, a weak housing market and stubbornly high unemployment is weighing on investor sentiment. Weakness in commodity markets and rotation into defensive sectors of the stock market testify to that shift.
With this week's ISM national manufacturing survey for May expected to show more weakness and payroll data tipped to show fewer than 200,000 jobs added during the month, risk aversion -- driven by fear about the economy -- could get worse before it gets better.
Goldman Sachs economist Zach Pandl said his firm is predicting 150,000 jobs were added in May, compared with a Reuters consensus of 185,000.
An ISM reading below 60 on Wednesday would show "the strongest period of growth has passed and investors may need to adjust their expectations going forward," said Michael Sheldon, chief market strategist at RDM Financial in Westport, Connecticut.
Economists in a Reuters poll expect the ISM reading to fall to 58 in May from 60.4 in April.
Goldman Sachs has also been tweaking its stocks outlook. It cut its year-end S&P 500 target, one of the highest on the Street, to 1,450 from 1,500, and lowered its 2012 earnings outlook to $104 to $106, citing lower global growth, higher commodity prices and slightly higher inflation.
Goldman analyst David Kostin, who is responsible for the S&P 500 target, was unavailable for an interview.
However Goldman's analysts wrote: "As we transition into the late expansion phase of the cycle later this year, the risk-reward balance for the S&P 500 is likely to become slightly less attractive."
Citigroup also slightly increased its earnings estimates for S&P 500 companies, lifting its 2011 forecast to $98 from $96.50. Although that is admittedly only a small increase in the earnings estimate, Citigroup chose to leave its S&P 500 target at 1,400.
Tobias Levkovich, Citigroup's chief U.S. equity strategist, could not be reached for a comment.
The targets for all three banks are still at the upper end of analysts' estimates and are 5 percent to 8 percent above current levels.
Even if the index does get up to those levels later this year, those gains are slight compared with the nearly 80 percent run the S&P 500 has experienced since hitting a bear market low in March 2009.
For people like Bill Strazzullo, partner and chief investment strategist at Bell Curve Trading in Boston, that means the risks are firmly on the downside.
"The good news is there's some upside. The bad news is that you've probably made about 80 (percent) to 90 percent of this rally," Strazzullo said. "From a 'bigger picture' standpoint, the risk-reward really doesn't make sense."
Strazzullo believes the S&P 500 will revert toward fair value, which he places at 1,100, based on where most of the money in the S&P 500 is invested. He is looking at some longer-term bearish options trades to capitalize on the end of the March 2009 rally.
"I'm not saying we'll go all the way back there, but the point is, you could drop a lot further than most people anticipate."