Does the Stock Market Have a Valuation Problem?
2024.12.07 13:56
Valuation & Growth
As we’ve seen over the past three years, stock investors don’t like recessions, not even the no-shows. There was much anxiety about an imminent recession from January 3, 2022 through October 12, 2022, as reflected by the 25.4% drop in the S&P 500 over that period.
Over that period, industry analysts confirmed investors’ fears by lowering their consensus expectations for the operating earnings per share (EPS) of the S&P 500 companies by 0.2% and 1.9% for 2022 and 2023. These were very modest cuts, so the forward earnings estimate based on the analysts’ annual estimates rose 5.8%.
(“Forward” earnings is the time-weighted average of the analysts’ consensus estimates for the current year and following one; the forward P/E is the multiple based on forward earnings.)
Nevertheless, recession fears caused investors to slash the forward P/E for the S&P 500 from 21.7 at the start of 2022 to 15.3 on October 12, 2022.
That was a 29.5% drop that was only partially offset by the 5.8% increase in forward earnings. The result was a P/E-led bear market.
Bear markets tend to bottom with forward P/Es well below the historical average of 15.8.
Yet, the latest one bottomed at a relatively high forward P/E because investors started to anticipate that recession fears might start to abate, as the economy proved remarkably resilient in the face of the significant tightening of monetary policy from March 2022 through August 2023.
So from 15.3 on October 12, 2022, the forward P/E rebounded impressively to 22.3 during the final week of November this year. That 45.8% increase in the S&P 500’s valuation multiple was bolstered by a 15.5% increase in the forward EPS. The result has been a solid bull market, so far, that has kept pace with the previous eight bull markets.
The point of this walk down Memory Lane is that the valuation multiple is a significant determinant of the stock market’s gains and losses. Through investors’ willingness to buy and sell at particular valuation levels, they amplify and anticipate changes in the consensus analysts’ expectations for EPS.
In our opinion, the key driver of the forward P/E is investors’ perception of how much and for how long earnings can grow before the next recession depresses earnings and the valuation multiple. Economic growth drives earnings growth, and investors’ expectations for both drive the forward P/E.
Investors will pay a higher P/E the longer they believe that the economic expansion will last. That’s because time is money. The longer the expansion, the longer that earnings have to grow to justify the current multiple.
That helps to explain the dramatic rebound in the forward P/E during the current bull market. When fears of a recession during 2022 became recognized as unfounded over the past three years, the rapid rise in the valuation multiple reflected investors’ increasing confidence that the economy and earnings would continue to grow despite the tightening of monetary policy.
So now what? The Fed has been cutting the federal funds rate since September 18. That certainly reduces the risk of a recession caused by the tightening of credit conditions and increases the odds of a long expansion.
If the tightening of monetary policy is no longer a risk to economic growth, what else might be? Perhaps a geopolitical crisis that causes oil prices to soar, as happened a couple of times during the 1970s? So far, the geopolitical crises since 2022 haven’t boosted the price of oil, which has been mostly falling since then.
That leaves a tariff war as a potential cause of a recession now that President Donald Trump is back and ready to slap tariffs on all of America’s trading partners. So far, stock investors aren’t fazed by Tariff Man, whom they believe is speaking loudly and carrying a big stick as a negotiating tactic. We agree.
Stretched Valuations
So now that we have explained why today’s high valuations might be justified, we must acknowledge that they are stretched by historical standards. We wouldn’t like to see them go any higher because that would force us to raise the odds of a 1990s meltup scenario from our current subjective probability of 25%.
Let’s review the latest readings on various valuation metrics:
(1) Trailing P/E. The four-quarter trailing P/E of the S&P 500, using reported earnings, rose to 27.1 during Q3-2024, well exceeding the 19.6 average since the late 1930s.
It bottomed at 20.5 during Q3-2022, above its historical average. It’s not a useful valuation measure, though, since it tends to soar during recessions as earnings fall faster than stock prices.
(2) Buffett Ratio. Many years ago, Warren Buffett mentioned that he likes to follow the ratio of the total value of US corporate equities at market value divided by nominal GDP. The Buffett Ratio rose to a record-high 2.96 during Q2-2024.
A useful weekly proxy ratio is the price of the divided by the forward revenues per share of the index (i.e., forward P/S).
It rose to a record 2.99 during the final week of November. Previously, Buffett noted that readings above 2.0 suggest that the market is getting overvalued. That might explain why he has been raising so much cash in the portfolio he manages for Berkshire Hathaway (NYSE:).
(3) Forward P/E. The forward P/E of the S&P 500 rose to 22.3 at the end of November.
That’s not at a record high, unlike the forward P/S ratio, because the S&P 500’s forward profit margin has been rising, boosting the growth of earnings relative to sales. Nevertheless, it’s closing in on the record high of 25.0 recorded during the Tech Bubble of 1999.
The S&P 500’s forward P/E has been boosted by the collective forward P/E of the Magnificent-7, currently 29.1, while the forward P/E of the remaining S&P 493 companies is at 19.5. Similarly, the median forward P/E of the S&P 500 was 19.8 during November.
(4) Fed Model. The Fed’s Stock Valuation Model compares the forward earnings yield of the S&P 500 to the Treasury bond yield. The two were highly correlated from the mid-1980s through the late 1990s.
They’ve diverged greatly since then. The model may be worth monitoring again now that the forward earnings yield at 4.46% is almost identical to the 10-year Treasury bond yield.
(5) Real earnings yield. The spread between the S&P 500 earnings yield based on reported earnings and the Consumer Price Index inflation rate tends to be negative during recessions and bear markets.
It has been slightly positive for the past six quarters.
