The stock market is not just expensive, it is extremely expensive. And yet history shows that it can record impressive gains from current levels.
The
S&P 500
has increased by almost 15% over the year. This comes as investors increasingly expect the Federal Reserve to hold off on further interest rate hikes, which are intended to cool the economy but are problematic for stocks because the inflation rate has already fallen. Also helping the market is the fact that shares of major technology companies have soared on hopes that artificial intelligence will make existing products more attractive and open the door to new ones.
The S&P 500 now trades at about 18 times the total earnings per share that each company is expected to generate over the next 12 months, well above the historical average of about 15 times. However, this doesn’t fully reflect how expensive stocks have become, especially given that the ratio has been above 20 for long periods in the past.
Whether the valuation of stocks is insanely high has a lot to do with the level of interest rates. Because the index trades at 18 times earnings, an investor can expect annual earnings per share of about $5.50 for every $100 invested in it.
That 5.5% is just 1 percentage point more than the roughly 4.5% that investors can earn by holding safe 10-year Treasury bonds. That extra return, known as the equity risk premium, is near a 20-year low and well below the long-term average of about 3 percentage points, according to Morgan Stanley.
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If the premium were at its historical average level, the S&P 500’s earnings yield would be 7.5%. That equates to an index trading at 13.3 times earnings, well below the current 18 times – a sign that the stock market is frighteningly expensive.
However, history shows that when the equity risk premium is as low as it is now, stocks tend to rise by double digits over the following year. If the S&P 500’s equity risk premium is between zero and 1%, the average performance for the following year is an increase of just over 12%, according to RBC.
If the equity risk premium is negative and the return on stocks is below that of the S&P 500, the index will continue to decline the following year.
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That’s not what’s happening now. There are many reasons why people would buy stocks, even if the equity risk premium is low.
Today the market is confident that earnings in the next few years will be significantly higher than Wall Street predicted, partly because this has happened recently. The economy continued to grow, defying expectations that the Fed’s efforts to combat inflation would trigger a recession, helping profits beat analysts’ estimates. Adding to the optimism is the expectation that Big Tech will post double-digit annual EPS growth in the coming years.
The likelihood of this favorable scenario occurring means analysts will eventually raise their profit forecasts. If stock prices stay where they are, the S&P 500’s forward price-to-earnings ratio would be lower, making the market appear less expensive.
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The earnings yield would rise while bond yields could fall, further increasing the equity risk premium. The 10-year yield is already about half a percentage point below its multi-year peak, which it reached in October. The average annual inflation rate is expected to be only about 2% over the next decade, meaning bond yields could fall.
“The downward momentum in the 10-year yield should increase (and that will provide a tailwind for stocks),” wrote Sevens Report’s Tom Essaye.
Investors are already thinking about how they can position themselves for this. RBC’s chief U.S. equity strategist, Lori Calvasina, wrote Monday that in calls with clients, “investors were interested in finding out what [stocks] to own when yields are at their peak.”
Can stocks continue to recover? That is a legitimate expectation.
Write to Jacob Sonenshine at [email protected]
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