Assets seem expensive, but that doesn’t mean they aren’t worth buying.


Our Top Market Takeaways for the week ending January 17, 2020.

Markets roundup

At long last

Pen to paper. Well, they finally did it. President Donald Trump and Chinese Premier Liu He signed the “Phase One” trade agreement. For a more in depth analysis, see Michael Cembalest’s latest Eye on the Market, but basically U.S. tariffs on Chinese imports will go down a touch for a promise by the Chinese to buy more American goods and to play more fairly in the currency and intellectual property spaces. This deal is not an end to the trade tensions, but it is an important sign that both parties seem committed to reducing uncertainty. Further, the political timeline indicates that President Trump may begin to focus more on his re-election campaign at home rather than maintain a second front in his fight against unfair Chinese trade practices.

One of the three major risks to markets over the last two years has been the trade war, and putting it on the back burner is clearly a positive. Over the last three months, markets have done a lot to price in the “Phase One” deal. The MSCI China Index is up +15.4%, and the S&P 500 is up +11.5%. Sectors that are particularly exposed to the tensions, such as semiconductors (+19.4%), have also rallied. Treasury yields have stayed relatively stable at around 1.80%, high yield spreads remain tight, and volatility is low. On Thursday, the S&P 500 closed at an all-time high of 3,316.

This powerful rally has made us re-examine our outlook. Have we gone too far too fast? Are assets overvalued? There is no doubt that current valuations at face value are not nearly as compelling as they were three months ago, but we think it still makes sense to prefer stocks to bonds.

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It’s hard to find a bargain these days

Assets seem expensive, but that doesn’t mean they aren’t worth buying. A simple way to think about the value of a financial asset is: “How much am I paying for the cash flow this asset entitles me to?” For stocks, the most common way to answer this question is to look at the price-to-earnings ratio, which is just the price of a stock divided by the earnings the stock is expected to generate. Right now, the S&P 500 is trading at about 3,300, and is expected to generate about $177 of earnings per share over the next 12 months. If you have a calculator, you already know that the 12-month forward price-to-earnings ratio of the S&P 500 is a little over 18.5x (3,300/177 = 18.5). That’s pretty expensive! For context, the index traded at a price of 18.3x in January 2018 (the previous high of the last 10 years), and at around 25x during the Tech bubble.

Stocks look expensive relative to their own history, but that doesn’t mean they are overvalued. Let’s compare them to their most likely substitute: bonds. When we talk about bonds, we usually talk about their yield, which is just the annual cash flow they generate divided by their price. To compare that to equities, we can just flip our price-to-earnings ratio to be the earnings expected over the next year divided by the price. This is called the equity earnings yield. Right now, the equity earnings yield is ~5.4% (1/18.5 = 5.4%). Meanwhile, the 10-year bond yield is ~1.80% (which is low relative to history, and in part reflects low inflation expectations). The spread between the two is ~3.6%. The wider the spread, the less expensive stocks look relative to bonds. Over the last 30 years, the spread between equity earnings yield and Treasury yields has only been wider 30% of the time. This suggests that stocks may be expensive relative to their history, but it is very hard to argue that they are overvalued relative to fixed income.

Stock valuations, relative to bonds, look just about right for the current environment.

When you zoom in, you can really see the picture. The chart shows the spread between equity earnings yield and the 10-year Treasury yield from January 2017 until now. The most overvalued that stocks looked when compared to bonds was in October 2018. Then, the price-to-earnings multiple was 16.6x (much lower than it is today), but 10-year Treasury bonds were yielding 3.23%! That means that investors were only receiving an extra 2.8% as compensation to hold equities rather than Treasury bonds. Given the risks that were mounting (a tightening Fed, a global manufacturing slowdown and an escalating trade war), investors didn’t think that was enough. Stocks sold off through the end of the year.

Chart showing the spread between equity earnings yield and 10-year Treasury bond yield from January 2017 through January 2020. The most overvalued that stocks looked when compared to bonds was in October 2018. Since that point, stocks have become less overvalued to bonds; the most that stocks were undervalued was in August 2019. Currently, we are somewhere in the middle of those two extremes.

On the other end of the spectrum, stocks were relatively undervalued back in August of 2019. At that point, the Fed was cutting interest rates, but the yield curve had inverted, there were still questions around the manufacturing cycle and the trade war, and recession fears were pervasive. The price-to-earnings multiple was 16.1x (which in part reflected these risks) and the 10-year Treasury yield had fallen to 1.53%. That means that equity investors could pick up 4.65% over Treasury bonds in spite of the risks that were present. In hindsight, buying stocks then was the right call: The S&P 500 has returned +16.4% versus 7–10 year Treasury bonds returning -1.2%.

Now, we are somewhere in the middle of those two points. Current stock valuations, relative to today’s low bond yields, look just about right for the current environment. The trick is that the current environment is fleeting. Valuations are fickle, and they change based on events that are impossible to foresee. That said, should we continue to see the economy grow at a trend-like rate (as we expect it to), we think low inflation, low bond yields and higher-than-average stock valuations could persist.

All things considered, this is why we are anchoring our outlook for U.S. equity upside on our view for earnings, which we think will grow by mid-to-high single digits. That should be more than enough to drive positive returns through the end of the year. Meanwhile, bonds are still a critical part of portfolios. If we are wrong, and something surfaces to blur the growth picture that seems clear now, bonds are likely to provide a buffer to portfolios.


All market and economic data as of January 2020 and sourced from Bloomberg and FactSet unless otherwise stated.

We believe the information contained in this material to be reliable but do not warrant its accuracy or completeness. Opinions, estimates, and investment strategies and views expressed in this document constitute our judgment based on current market conditions and are subject to change without notice.


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