The Market Is Extremely Expensive. Don't Sell Your Stocks. -- Barrons.com

By Jacob Sonenshine

Most investors know that the stock market is super expensive, and that a recent flurry of selling has sent the S&P 500 down about 2% from the record it hit in late October. That doesn't mean investors should get out.

A look at what has been happening over the past few years, from stocks to bonds to the overall economy, explains why.

The index has been in a bull market, posting double-digit annualized gains over the past couple of years, and now trades at 21.5 times the earnings expected for the coming 12 months. The multiple is near the high end of its range in the past three years and well above 19.1, the average for that period, according to Barron's calculations based on FactSet data.

The fact that it is above average, on its own, doesn't necessarily mean the market is too expensive. Certain factors can elicit a multiple of nearly 22 times, namely falling interest rates and bond yields, as well as an investor base that is confident in earnings growth.

And there has been ample reason to expect profits to keep rising. The technology heavyweights in the index are using artificial intelligence to enhance their software or sell more chips, spurring higher earnings growth, while nontech companies are expected to benefit as the economy grows and the Federal Reserve cuts interest rates.

The catch is that, right now, this valuation level does look too high.

That is because bond yields could easily remain elevated. The yield on 10-year Treasury debt is just over 4.2%. Not even the Fed's half-point cut in short-term interest rates in September could move the 10-year yield lower. Lower short-term rates may stimulate the economy and add to inflation, while spending plans from both presidential candidates would do the same. The result is that yields have crept higher since the middle of September.

The 10-year yield makes the S&P 500 look particularly expensive. The index's current valuation means that for every $21.50 an investor pays to own the index, they can expect to receive $1 of earnings for the coming 12 months, for a 4.65% yield in theory.

That is only 0.45 percentage point above the yield on the ultrasafe 10- year note, so the index offers minimal additional return as compensation for taking the risk of being in equities. Historically, the expected return on the S&P 500, not counting gains in price, is a bit over 3 percentage points higher than the 10-year Treasury yield.

Still, the S&P 500 remains within shouting distance of its record high. It was inching higher on Monday morning, a sign that investors aren't particularly concerned.

The reality is that stocks can remain in bull mode for a long time, even when they are expensive. The S&P 500 began three stretches -- March 1998 to March 2000, April 2020 to January 2022, and January 2024 through Friday -- with a forward earnings multiple of above 20 times. From the beginning of each of those periods, the index posted annualized returns of anywhere from 18% to 34% to the market's peak, according to Evercore ISI.

It would be a shame to miss out on gains of that size, especially because any drop that might follow could be shallow.

The market could indeed keep rising: The conditions are in place for a continued bull market. The rate of inflation is almost down to the Fed's target, which means the central bank will probably keep cutting interest rates to keep the economy growing. Even if economic strength keeps the 10-year yield elevated, weighing on the index's price/earnings ratio, better corporate earnings would keep the S&P 500 trudging higher.

Of course, if that doesn't happen, the bull market could easily end in tears. "What ends the bull is one of three setups: recession, "irrational" exuberance, or "Uncooperative" Fed policy," writes Evercore strategist Julian Emanuel.

But irrational exuberance is only lives up to its namesake -- irrational -- if the market is ignoring signs of recession or that the Fed won't cut rates. Today, there are no such signs, so the bull market is likely to continue.

Stay invested.

Write to Jacob Sonenshine at jacob.sonenshine@barrons.com

This content was created by Barron's, which is operated by Dow Jones & Co. Barron's is published independently from Dow Jones Newswires and The Wall Street Journal.

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November 04, 2024 14:19 ET (19:19 GMT)

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