Federal Reserve Chair Jerome Powell stirred discussions among investors on Tuesday by remarking that the US equity market is “fairly highly valued.” His comments, though not welcomed in a typically bullish environment, echo sentiments that have been circulating in financial circles for some time. The current stock market, based on various valuation metrics, is notably expensive. Bank of America highlighted this concern, revealing that 19 out of 20 valuation metrics it monitors indicate the market is historically overvalued, with four measures reaching all-time highs.
One key indicator contributing to this perspective is the Shiller CAPE ratio, which compares the S&P 500’s price to a 10-year average of earnings. As of this week, this ratio has ascended to levels not seen since the dot-com bubble, signaling potential challenges for long-term returns. Historically, elevated values on the Shiller CAPE ratio correlate with disappointing returns over the following decade, suggesting that much of the future earnings potential has already been factored into current stock prices.
However, experts caution against solely relying on this metric. Yale economist William Goetzmann noted that the Shiller CAPE ratio, due to its 10-year averaging approach, can be slow to adapt to present economic realities, which diminishes its predictive power. “Every observation is just moving forward one year, so you have a lot of correlation between observations,” he stated, emphasizing the challenges of drawing definitive conclusions from such overlapping returns.
Tom Essaye, founder of Sevens Report Research, echoed similar sentiments, suggesting that while the Shiller PE ratio is informative, investors should focus more on forward-looking metrics, as past performance does not dictate future outcomes.
The forward PE ratio, which evaluates the S&P 500’s current price against expected earnings for the next year, is likewise elevated. Currently positioned at 22.2 times earnings, this figure rivals valuations seen during the peaks of 2021 and the dot-com era.
Moreover, the S&P 500’s price-to-book value, an indicator that contrasts the index’s price with its underlying asset value, has also reached unprecedented highs, surpassing levels established during the dot-com bubble. Similarly, the so-called Warren Buffett indicator—representing total stock-market capitalization in relation to GDP—is currently at an all-time peak.
While high valuations inherently raise concerns, they do not categorically predict poor future performance. Improved earnings relative to stock prices could alleviate some of that pressure on valuations. Bank of America’s chief US equity strategist, Savita Subramanian, noted that there are ways to mitigate the impact of inflated multiples, such as through significant sales or earnings growth. She suggested that perhaps the market should adapt its expectation of multiples to reflect today’s environment rather than revert to historical averages.
Subramanian’s insights recall the pre-1929 stock market crash rhetoric of economist Irving Fisher, who famously claimed that stocks had reached a “permanently high plateau.” She argues that the S&P 500 today might represent a higher-quality index compared to previous decades. Key characteristics of stability, including a lower debt-to-equity ratio and reduced earnings volatility, underscore her position that modern investors may be justified in their willingness to accept higher multiples for what they perceive as more predictable assets.
As the market grapples with these valuations, investors remain vigilant, weighing the historical context of these metrics against the evolving landscape of the economy and corporate performance.
