Stocks are richly valued today, but they’ve been more expensive at times in the past. High valuations imply unimpressive long-term returns, but they have no relationship at all to how the market does in a given year.
Even a pricey stock market can be made to look reasonable when compared to certain other assets. And there’s a big difference between a market that’s pricing in a lot of good news and a genuine bubble.
In other words, for a concept that seems all about hard numbers and observable relationships, there is plenty of nuance and subjectivity in assessing equity valuations.
Right now, it’s hard to deny that on the whole, stocks are rich relative to past earnings and forecast earnings. The trailing price/earnings ratio of the median U.S. stock, tracked by Ned Davis Research, has never been higher.
Based on 2021 forecasts, fewer than a third of the companies in the S&P 500 trade for under a 15 P/E, the rough long-term average trailing multiple. It’s a list packed with banks, insurers, “post-growth” Old Tech and slow-moving drug distributors.
This battery of valuation tests from Goldman Sachs shows the market to be at or near the most-expensive levels in recent history on most measures:
Strategists looking to make the upbeat case for paying up for stocks zero in on those two “yield gap” indicators. These compare the S&P’s earnings yield – forecast profits divided by stock price – to Treasury and investment-grade bond yields.
Stocks vs. bonds
Here there appears to be a valuation cushion on a relative basis. Federal Reserve Chair Jerome Powell last month implicitly endorsed this method by saying it does not suggest stocks are worryingly overvalued.
Of course, most investors leaning on this relative-value approach find bonds unattractively expensive, and therefore think their yields “should” be higher. There is also no historical support for an enduring relationship between stocks and bonds measured this way. Through the entire 1990s bond yields were always higher than earnings yields, since 2000 always lower. And while low interest rates perhaps explain higher equity valuations, they don’t “excuse” them in the sense of promising good future stock-market returns.
Citi Private Bank strategist Robert Buckland, in a report meant to assess claims that stocks are in a bubble, notes that in Japan in the 1980s or the U.S. in the late-’90s, government bond yields exceeded 5%. And investors’ willingness to forgo that safe return and keep bidding shares higher was part of what built those bubbles:
“In those instances,” he says, “income looked increasingly attractive as equities decoupled and moved to crazy valuations. As the equity bubbles burst, bond markets sucked in capital and share prices collapsed.”
Again, very low bond yields today don’t “forgive” high absolute valuations, but do make them seem less irrational and more continuous with generally elevated asset values.
Not crazy based on cash flow
The other way stock values today look less extreme is based on corporate free cash flow. This speaks to the changed makeup of the S&P 500, weighted toward higher-return businesses, as well as lower tax rates and slimmer debt costs.
Here the free cash flow yields of the S&P 500 and Nasdaq 100 are shown plunging – meaning valuations are much higher. But they’re no more extreme than they were last summer. And high-grade bond yields of 2% mean companies are still able to finance themselves quite cheaply and in a world of scarce cash flows, can maintain current multiples especially with profits set to resume growing.
Michael Batnick of Ritholtz Wealth Management points out that Apple, Alphabet Amazon, Facebook and Microsoft collectively generated more than $200 billion in free cash flow in 2020.
Together these stocks have a $7.8 trillion market value, and free cash flow should grow close to 20% this year. That computes to about 33-times free cash flow for some of the best businesses ever created. Certainly not cheap, but probably not crazy either – and well short of Nasdaq’s valuation in 2000.
The summer surge in the indexes was dominated by a handful of mega-cap Nasdaq stocks being repriced aggressively in a world short of reliable cash streams of any form, as “real” inflation-adjusted bond yields sank into negative territory.
That dynamic seems largely to have played out. The recent burst higher in more cyclical stocks as an economic rebound came into view rebalanced the market somewhat – even if those cyclical or “value” stocks are also stoutly valued and without the pristine business economics of the tech behemoths.
Valuation as market timer
The fact is, valuation is more a background condition than a here-and-now driver of market direction. When financial conditions remain very loose and the direction of expected earnings is up, there tends not to be a general reckoning due to high valuations – even if expensive stocks have more to lose once the air starts coming out.
Once the reliable growth-company cash flows became valued pretty tightly against falling fixed-income yields and compressed credit spreads — to the satisfaction of disciplined quantitative investing models — the market’s most aggressive energy has gone racing toward “pre-profit” growth companies, long-shot emerging growth, lightning-in-a-bottle IPOs, “total addressable market” plays and alchemy-promising SPACs.
There is the big-cap complex carrying the bulk of the market’s value and earnings, and there is a distinct “greed hive” that’s buzzing with options speculation, engineered short squeezes and heedless momentum buying of marginal, illiquid stocks. One of the most-shared charts last week showed a Goldman Sachs index of money-losing tech stocks having gone vertical in the past couple of months.
This is the action that will likely create instability if it continues spiraling at this clip. In 1999, this sort of thing kept rolling until the Nasdaq doubled in less than a year and a few-hundred IPOs hit the market.
Would a disturbance in the speculative precincts of the market lead to a more inclusive or lasting comeuppance for the major indexes? It’s not clear it would have to. The vulnerability of the market right now is probably less the high valuations at the index level and more the price-insensitivity run rampant in the greed hive.
