The stock market isn’t just expensive, it’s very expensive. However, history shows that significant gains can be recorded from current levels.
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S&P500
That’s an increase of almost 15% for the year. This comes as investors increasingly hope the Fed will hold off on further rate hikes, which are meant to cool the economy but would be a pain for stocks as inflation is already falling. is. Also boosting the market is the fact that Big Tech stocks are surging on hopes that artificial intelligence will make existing products more attractive and open the door to new ones.
The S&P 500 index currently trades at about 18 times the combined earnings per share that its constituent companies are expected to generate over the next 12 months, well above the historical average of about 15 times. But this doesn’t fully reflect how expensive the stock has become, especially given that this ratio has remained above 20x for long periods in the past.
Whether a stock’s valuation is abnormally high has a lot to do with the level of interest rates. The index trades at a P/E ratio of 18 times, meaning that investors can expect to earn about $5.50 per share annually for every $100 invested.
This 5.5% figure is only 1 percentage point higher than the 4.5% or so that investors would earn by owning safe 10-year Treasuries. This additional return, known as the equity risk premium, is near the lowest level in 20 years and well below the long-term average of nearly 3 percent, according to Morgan Stanley.
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If premiums were at historical average levels, the S&P 500 would have an earnings yield of 7.5%. This equates to the index trading at a P/E ratio of 13.3x, well below the current 18x and indicating that the stock market is horribly overvalued.
However, history shows that when a stock’s risk premium is as low as it is today, stock prices tend to rise by double digits next year. According to RBC, if the S&P 500’s equity risk premium is between zero and 1%, the average price move over the next year will be more than 12% higher.
The index will continue to decline in the next year if the risk premium on stocks is negative and the yield on stocks is lower than the S&P 500.
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That’s not what’s happening now. There are many reasons why people buy stocks even when the equity risk premium is narrow.
The market is now confident that earnings will significantly exceed Wall Street expectations in the coming years. One reason for this is that such things have been happening recently. The economy continued to grow, defying expectations that the Fed’s anti-inflation measures would cause a recession, and profits exceeded analysts’ expectations. Expectations that Big Tech companies will post double-digit annual EPS growth over the next few years are also fueling optimism.
The possibility of this favorable scenario materializing means analysts will eventually raise their earnings estimates. If stock prices remain as they are, the S&P 500’s forward price-to-earnings ratio will decline, making the market look cheap.
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Earnings yields will rise, while bond yields will fall, potentially further increasing equity risk premiums. The 10-year Treasury yield is already down about 0.5 percentage point from its multi-year high in October. Average annual inflation is expected to remain around 2% over the next 10 years, suggesting bond yields may fall.
“The downside momentum in 10-year Treasury yields should strengthen (and that should be a tailwind for stocks),” said Tom Essay of Sevens Report.
Investors are already considering how to position for it. “Investors were eager to explore what’s going on,” Lori Calvasina, RBC’s chief U.S. equity strategist, wrote Monday in conversations with clients. [stocks] You will own it when the yield peaks. ”
Will stock prices rise? That’s a natural expectation.
Email Jacob Sonenshine at jacob.sonenshine@barrons.com.
