The price/earnings ratio on the S&P 500, measured against the past 12 months of earnings, is at its highest level since 2002.
Photo: Corine Sciboz/Zuma PressThe record close that the S&P 500 hit last Tuesday, its first since February, has reignited the longstanding debate over whether high valuations are setting stocks up for a fall.
The index is now up more than 50% from its low this spring, erasing all the losses it suffered during the coronavirus pandemic. Despite a bruising recession, many investors appear to be betting the worst of the economic pain is past and that corporate earnings, the most reliable driver of stock prices, will begin climbing again next year.
That said, many on Wall Street question how long the market can continue rising at a time when unemployment is the highest in a decade and politics appear as unsettled as they have in years. On top of that, there is the simple matter that recent price gains come as earnings have been under tremendous pressure, leaving valuations stretched and many traders expecting increasing volatility.
“The only way to go higher on valuation is to duplicate the last few years of the 1920s or the 1990s,” said Barry Bannister, head of institutional equity strategy at Stifel, referring to periods when the economy was booming.
The price/earnings ratio on the S&P 500, measured against the past 12 months of earnings, stands at 25.26, according to FactSet. That is the highest level since 2002. The forward P/E, measured against earnings expectations for the next year, is at 25.98—a mark last hit in September 2000.
And the valuation of the median stock in the S&P 500, measured by forward P/E, is now in the 100th percentile of historical levels, according to Goldman Sachs Group Inc., going back four decades—the highest level possible. The index itself is trading at the 98th percentile.
Another valuation measure, called the CAPE ratio, or Shiller P/E, is even higher. That metric looks at the past 10 years of earnings and adjusts for inflation. The benefit, according to economist Robert Shiller who popularized it, is that it provides a longer-term look at valuation.
The CAPE ratio has risen as high as 30.63 as of Aug. 11, a level that has rarely been exceeded over the past century. In December 1999, it peaked at 44.20. In 1929, it rose as high as 32.56.
Not only is the stock market running ahead of the economy right now; it has been for years. The “Buffett Indicator,” named for legendary investor Warren Buffett, compares the total market capitalization of publicly traded stocks to gross domestic product. The Berkshire Hathaway chief executive has said that when the market cap of public companies is higher than GDP, the market is overvalued.
In that case, the market has been overvalued for more than a decade. The last time that GDP was higher than the equities market’s total capitalization, adjusting both for inflation, was in 2009, when the stock market’s total capitalization was only about 93% of GDP.
Since then, the market value of U.S. companies has at times approached double GDP. Their collective market cap currently stands at $35.7 trillion, according to the World Federation of Exchanges, down from $37.5 trillion at the end of 2019. GDP in the second quarter ran at a seasonally adjusted annualized rate of $19.4 trillion.
Many investors appear to be pinning their hopes on a coronavirus vaccine and extensions of jobless benefits and other stimulus from Congress. Any hiccups on those fronts could stall the market’s recent rally. At the same time, volatility is expected to remain elevated through the beginning of next year due to the coming presidential election, which is likely to be contentious.
Stocks might look expensive against those concerns, but some market watchers say it is difficult to reliably predict when valuations are too rich for investors’ taste.
“Market rules are not written in stone,” said Robert Colby of Robert W. Colby Asset Management, which has $20 million in assets under management. “Sometimes there’s just no logic to market behavior.”
Write to Paul Vigna at paul.vigna@wsj.com
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