Stocks look expensive relative to history. But are they too high?
Joe Warsh, Global Market Strategist
Stephen Jury, Global Market Strategist
Our Top Market Takeaways for September 11, 2020.
A day of remembrance: September 11
Today marks the 19th anniversary of the September 11 terrorist attacks that took the lives of thousands. Here, we take a moment of pause to remember the victims, be mindful of those who grieve, and honor the heroes who responded to the tragedy.
A rollercoaster of a week. This week, the U.S. markets couldn’t seem to shake the downward momentum that started at the end of last week.
In the United States, trading has been characterized by a growth pullback that we attribute to an overcrowded trade that had extended valuations, some profit taking, and a potential rotation into value names that could benefit from reopening momentum.
This has left the S&P 500 and NASDAQ 100 -6.7% and -10.2% off their all-time highs, respectively. Even with this sell-off, however, the S&P is up +3.4% and the NASDAQ 100 is up +27.7% on a year-to-date basis.
While we can never say with certainty if a sell-off is over or if the coast is clear to buy the dip, for long-term investors this should be a fine entry point; nothing has changed since we wrote “We are more optimistic. Why you should be too.” last week, and we continue to believe in the digital transformation trend that is remaking life and business around the world. Despite this, we acknowledge lingering concerns that the market is too expensive after its epic run. Today, we will focus on how we are thinking about market valuations at these levels.
But before we get into it, we’ll highlight some notable headlines from the week.
- A fourth round of fiscal stimulus is growing increasingly unlikely before the presidential election. Yesterday, Democrats blocked the GOP’s $500 billion relief proposal, as there remains a wide gap between the two sides on the scale of a new package. The clock is ticking too, as the focus will soon shift to the final campaign stretch, and the need for a short-term budget deal to avoid an October 1 government shutdown. Failure to pass a new stimulus would certainly disappoint markets and throw cold water on the pace of recovery, though it shouldn’t cause a “double dip” back into recession.
- The AstraZeneca/Oxford vaccine trial was put on hold, but the CEO says it could still be ready for approval by the end of the year. The pause follows news on Wednesday of a participant’s serious adverse reaction. While they aren’t necessarily sure the adverse reaction was from the vaccine, setbacks like this are not unusual, and need to be investigated properly. On Thursday, AstraZeneca’s CEO expressed hope that the vaccine could still be approved by the end of the year. Notably, this is one of three high-profile candidates in Phase 3 trails.
- A woman will be the CEO of a major U.S. bank for the first time. Citi has become the first major bank to name a woman as CEO. Current CEO Michael Corbat, who is stepping down in February, announced that the board selected Jane Fraser, Citi’s President and CEO of Global Consumer Banking, to succeed him. An exciting development to be sure!
- Football is back, after what felt like a very long offseason. Super Bowl MVP Patrick Mahomes and the Kansas City Chiefs picked up where they left off, as the defending champions took down the Houston Texans in last night’s game. Yesterday was actually the first day ever that all six major sports leagues (NFL, MLB, MLS, NBA, WNBA, NHL) played on the same day. With the U.S. Open tennis championships wrapping up this weekend and the U.S. Open golf tournament on next week, sports are now back in full swing…that is, with limited to no fans.
How high can equity valuations go?
First, some background. Equity returns come from three sources: changes in earnings expectations, changes in the price investors are willing to pay for those earnings, and the dividend that companies pay to shareholders. From August 31, 2019, to August 31, 2020, U.S. equities returned +24%. The biggest factor was from a ~35% increase in the price-to-earnings (P/E) ratio (the valuation metric that measures just how much investors are willing to pay for the next 12 months of earnings). Over the last 12 months, equities have gotten much more expensive relative to their expected earnings.
After this week, the S&P 500 is trading at a ~22x forward earnings multiple. That’s high. The historical average multiple over the last 25 years is 16.4X…so just looking at that, it’s pretty easy to conclude that the stock market seems expensive.
Is the stock market too expensive?
Well, it certainly isn’t cheap, and just looking at the history of P/E multiples will lead you to that conclusion. However, the last 25 years of market history took place in an entirely different economic landscape and with higher interest rates. Today, the Fed has cut the policy rate to zero and has committed to keeping it there for the foreseeable future. Interest rates are critical to understanding valuations because when interest rates are low, there are fewer attractive options for investors. For example, if you could go get a 6% risk-free yield from a government bond, that might be pretty tempting! But you can’t do that, because interest rates are near historic lows. This makes stocks more valuable to investors. More technically speaking, low rates mean the rate at which investors discount future cash flows is also low, which makes future cash flows from earnings more valuable.
The truth is, there is really no historical precedent for this, and therefore we think that historical comparisons of P/E multiples should be taken with a grain of salt. We’re not saying to entirely toss them out…the history exists and it’s real. We just need to reconfigure how we think about valuations to take account for this new world in which we find ourselves investing.
Could P/E multiples go higher? If so, how high?
The honest answer is that we don’t really know. As we said earlier, we’ve never dealt with these particular circumstances before, and we won’t know the answer until we’ve hit the top and come back down. What we do know is that the market made a high of 24.5x in 1999 at the height of the technology bubble. But before you freak out, consider:
The biggest difference between 1999 and today is that this time, the technology rally is being driven by blowout earnings. In 1999, it was simply the idea of what the internet could become (U.S. 10-year Treasury yields were also above 5.5%). So on that basis, it would be fairly easy to build the case that multiples can run as high as 25x in this cycle. Assuming a 2021 EPS estimate of $170 (which is what the bulls would argue should be the floor for expected earnings), that would put the S&P at 4,250, or ~25% higher than it is today! That’s not our base (or even bull) case, but it’s certainly not impossible.
Tying it all together.
We don’t think investors should get too hung up on how expensive the market looks today. With rates at historic lows, future earnings are much more valuable to shareholders. The market will be willing to pay for those earnings with a higher multiple for some while yet…possibly years, as interest rates are unlikely to head higher anytime soon, especially now that the Fed has moved to average inflation rate targeting. We aren’t saying ignore it, but it’s not as big of a factor as it used to be.
Signs of the times
Californians woke up to a Martian view. If you didn’t see it on Instagram, smoke from the devastating wildfires across the West Coast obscured the sun and cast an eerie rusted tone across the San Francisco Bay Area. In another sign of the times, we are only halfway through hurricane season, but we’ve already had 16 named storms. The next one will be named “Sally,” and the last time we got to “S” was with Superstorm Sandy, which formed in late October of 2012. Climate change is becoming even more costly, and markets may be waking up to the idea that clean energy will become a global focus. A basket of clean energy companies is up almost +40% so far this year, while the global traditional energy sector is down by -40%.
All market and economic data as of September 2020 and sourced from Bloomberg and FactSet unless otherwise stated.
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