MW Yes, stocks are crazy expensive right now. These 5 charts show just how extreme valuations have become.
By Joseph Adinolfi
A popular metric shows stocks haven't been this richly valued since the dot-com era
There's no getting around it. Shares of America's largest companies have been looking pretty expensive lately.
The thinking holds whether looking at valuation metrics based on corporate earnings over the past decade, or Wall Street's expectations for profits and sales over the coming year. Major gauges for measuring how expensive stocks have become, relative to their fundamentals - including the earnings and sales these companies stand to reap - send a similar message: Prices for U.S. large-cap stocks haven't been this elevated since at least 2021. That was right before the bull market that followed the advent of the COVID-19 pandemic reached a peak.
For many investors, high valuations can be reason enough to question whether stocks look like a smart buy at current prices. But strategists who spoke with MarketWatch also offered a word of caution: just because stocks look expensive, doesn't mean they can't get more expensive.
"What we've found is that valuations aren't a particularly good timing indicator," said Rob Haworth, senior investment strategist at U.S. Bank, during an interview with MarketWatch.
See: Wall Street is worried stocks might be on the cusp of a 'lost decade'
Keep that in mind while perusing the five charts below, which offer a picture of some of the most commonly used metrics employed by financial analysts.
CAPE
The CAPE ratio, or cyclically adjusted price-to-earnings ratio, compares the price of a stock (or index) to average earnings over the previous decade, while taking care to adjust for inflation.
It was developed by Robert Shiller, an American economist and a Nobel Prize laureate in economics.
For the S&P 500 SPX, the ratio rose as high as 38.11 in November, its highest level since late 2021, according to data featured on a website maintained by Shiller. Prior to that, it has only been higher around the peak of the dot-com bubble.
Price-to-sales
The forward price-to-sales ratio also has been giving investors dot-com-era vibes.
The level of the S&P 500 compared with its member firms' expected earnings over the coming year rose as high as 2.98 earlier this month. At that level, it has surpassed its recent highs from 2021, and was nearing its record peak north of 3 from the summer of 2000.
Most equity strategists consider a price-to-sales ratio above 3 to be extremely expensive.
However, individual stocks also trade at many times that level, including Palantir Inc. $(PLTR)$, which recently boasted a forward price-to-sales ratio just shy of 40, according to FactSet data.
Steve Sosnick, chief strategist at Interactive Brokers, said that in some ways, price-to-sales offers a more accurate picture of a stock's valuation.
That's because companies have far less discretion to make adjustments to raw revenue numbers.
"It's easier for companies to massage their earnings than it is to massage revenues or cash flows," Sosnick told MarketWatch during an interview.
Price-to-earnings
This was, perhaps, the most widely used of the metrics included here.
The forward price-to-earnings ratio for the S&P 500 crossed above 22 in November for the first time since 2021, Dow Jones Market Data showed. This means stocks were richly valued relative to the profits these firms were expected to generate over the next 12 months.
The Buffett Indicator
Relative to the size of the U.S. economy, stocks have never been more expensive.
Taken together, every stock in the S&P 500 was worth 1.7 times the entire U.S. gross domestic product as of the end of the third quarter this past week.
Some call this "the Buffett Indicator," although we should clarify that the standard version of the Buffett Indicator uses the Wilshire 5000, an index that captures all actively traded U.S. stocks, rather than the S&P 500.
But given that the S&P 500 captures the majority of total U.S. stock-market value, there lately has been very little daylight between the two ratios.
The indicator got its name from a comment Berkshire Hathaway Chief Executive Officer Warren Buffett once made to a reporter years ago, when he said that comparing the market capitalization of all U.S. stocks to the size of the U.S. economy offered the clearest picture of where valuations stand at any given moment.
However, the "Oracle of Omaha" has since distanced himself from his namesake indicator. One of Buffett's assistants told MarketWatch a few months ago that throughout his adult life, Buffett has cautioned against trying to predict stock-market behavior.
Recently, some investors have been paying more attention to another Buffett indicator - the man himself. Berkshire's decision to sell some stocks and build up its cash reserves has made some on Wall Street nervous.
Cash and equivalents, plus short-term U.S. Treasury investments, held by the conglomerate rose to $325.2 billion in the third quarter, a record high.
But before panic sets in, it's worth pointing out that increases in Berkshire's cash holdings have had little predictive power for markets in the past, according to one stock-market strategist.
Equity risk premium
Compared with historically elevated returns investors can reap from holding Treasurys backed entirely by the U.S. government, stocks may no longer offer a compelling return, given the additional risk.
At least, in theory.
The equity risk premium, which compares the S&P 500's expected earnings yield with the actual yield on the 10-year Treasury note BX:TMUBMUSD10Y, slumped to its lowest level since 2002 this week, according to MarketWatch's calculations.
While a negative premium suggests more risk-averse investors might want to stick with Treasurys and steer clear of stocks, the "ERP" in the past has remained in deeply negative territory for years, while the stock market kept on climbing. That was the case in the late 1990s, and it remained in negative territory as stocks tumbled after the dot-com bubble burst.
More conservative strategists have been howling about the decline in the ERP largely since the bull-market began. Its decline since the start of 2022 has mostly been driven by a rise in Treasury yields to levels last since before the 2008 financial crisis.
A new normal?
Moreover, while many stocks look expensive, it doesn't mean investors can't still find a good deal.
Small-cap and mid-cap stocks still look relatively cheap, several strategists told MarketWatch. Underperforming S&P 500 sectors remain, like healthcare stocks, materials and real-estate investment trusts.
But before diving into the bargain bin, it's worth considering that the higher valuations of today might actually be justified. Some analysts think comparing today's stock market to the market of yesteryear simply doesn't make much sense.
That's because, since the 1990s, the technology boom unleashed by the internet has changed many aspects of the U.S. economy.
And as long as companies like Microsoft Corp. $(MSFT)$, Apple Inc. $(AAPL)$ and Nvidia Corp. $(NVDA)$ can defend the sizable moats surrounding their businesses and continue growing earnings at a solid pace, investors have good reason to pay a premium for their shares, according to Nicholas Colas, co-founder of DataTrek Research.
Indeed, many of the biggest companies in the S&P 500 boast wider profit margins and lower debt than their predecessors from decades past. These firms tend to be "asset light," meaning they don't require heavy investment in factories and other capital goods. Because of this, their earnings have been much more stable from quarter to quarter.
All of this helps to justify higher earnings multiples, according to Ohsung Kwon, a strategist at Bank of America global research.
"Yes, valuations are more expensive today versus historical levels for sure," Kwon said. "But there are reasons why multiples should be higher."
Mike DeStefano contributed reporting
-Joseph Adinolfi
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(END) Dow Jones Newswires
November 16, 2024 07:00 ET (12:00 GMT)
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