US Stock Market Valuations
What would Goldilocks say?
There is a lot of red on investors’ screens these days, as both stocks and bonds have sold off significantly in the past few weeks. The S&P 500 is off 7% year to date, the Nasdaq is down 12% and the 10-year UST note now yields over 2%. Exxon and Bank of America shares are up but many tech stocks are getting hammered, with Meta (Facebook) down 35%, Tesla down 20% and Microsoft down 12%. Investors who were strategically underweight equities in 2021, when the US stock market returned close to 30%, are finally having their long-overdue “I told you so” moment. Schadenfreude is not an attractive emotion, but it is certainly an understandable one at times like these.
But what are we to make of current equity market valuations? Are US stock prices too high, too low or just about right? Compared to what? And how should the answer to this question influence the positioning of investor portfolios and corporate capital allocation decisions?
I have no idea whether stocks are currently over or undervalued, and neither do most of you. Stocks can be deemed “cheap” or “expensive” only when compared to something else, such as the past valuation of stocks, past and future corporate earnings, or the price and yield on bonds. And so we need to look at each of these drivers of equity valuations when evaluating the current pricing of US stocks.
The US stock market has generated average annual returns of 25% over the last three years and 15% or so over the past 10 years, which is quite unusual by historical standards. As a result, equity prices are now quite high and it would not be unreasonable to anticipate a period of significant mean reversion of annual returns. When this might occur, and how big a correction we might see, is far from clear however. And of course many investors continue to see value in US stocks, even at current prices.
Since the financial crisis of 2008-9, the US stock market has been supported by a number of major government initiatives, including unprecedented amounts of monetary policy and fiscal stimulus, most recently in response to the covid pandemic. Short-term interest rates have been at or close to 0% for over a decade now and UST bond yields have generally been in the range of 1-1.5% until very recently. Corporate tax rates were slashed in 2017, generating large increases in corporate earnings and driving up equity valuations. US federal government spending has increased by $7tn just over the past two years, a large portion of which has been effectively monetized by the Fed. Given this backdrop, investors reasonably concluded that there really was no alternative to stocks and the resulting money flows pushed up the price of stocks substantially.
But this picture is changing rapidly, as the government’s covid stimulus programs expire and the Fed begins to reverse course on monetary policy. And investors are having some trouble figuring out how to value stocks in this rapidly changing environment.
With sovereign bond yields now above 2% in the US and increasing across the world, we are beginning to see some more interesting investment alternatives to US stocks. Although the US economy remains strong and corporate earnings are booming, providing continuing support to equity valuations, the discount rate at which investors value future corporate earnings (cash flows) is also increasing. And this rise in discount rates likely accounts for much of the recent correction in the equity markets, particularly in the high growth (low current earnings) tech sector.
The current Price/Earnings (P/E) multiple on the S&P 500 is around 20x, a bit higher based on 2021 earnings and a bit lower based on 2022 forecasts. A P/E multiple of 20x corresponds to a current earnings yield (E/P) of 5%, a 300bp premium over the current yield on the 10-year UST note (2%). This may not seem like much of a premium to warrant taking substantial equity risk, but keep in mind that US corporate earnings have been quite strong recently and may continue to grow strongly for some time to come. And if investors generally expect this to happen, the forward P/E multiple of the US stock market based on current prices will fall and the earnings yield will increase, making stocks look cheaper than they might otherwise seem based on current earnings levels.
This picture looks quite different, however, if we compare the current price of US stocks not to the much improved level of corporate earnings in 2021-22 (or beyond) but rather to average historical earnings over the course of a full business cycle, say for the past ten years (2012-21) This is the methodology of the well-known Shiller CAPE (Cyclically Adjusted PE) ratio, which currently values the US stock market at 36x earnings. At 36x, the Shiller CAPE is 80% higher than the conventionally calculated P/E multiple of 20x. It is also well above the CAPE ratio calculated for 1928 (32x) although still well below the level in 1999 (44x), both years preceding major stock market crashes. But before you rush to sell all your stocks tomorrow, please note that many equity investors do not put much faith in the CAPE ratio, and even Professor Shiller disowns it as a market timing device. But it is probably fair to say that the high current CAPE ratio should perhaps give us reason to pause before we argue too strongly that US stocks seem undervalued at current prices.
It is at times like this that I am particularly glad that I do not teach investment management, but the question of equity market valuation is also quite relevant to my primary area of professional focus, corporate finance. The current valuation level of US stocks is relevant not only to portfolio allocations in the investment management world but also to capital allocation decisions in the real economy and in the world of corporate finance. How should corporate executives and directors think about the expected return on proposed capital investment projects? Is now a good time to engage in M&A, as either a buyer or seller? How should companies finance their capital investment projects, with debt or equity? These are the sorts of questions we ask regularly in the world of corporate finance, and the answers we come up with depend at least in part on how we feel about current equity valuations and the price of the stock market. (Of course matters like inflation and supply chains are also very important, and probably dominate much current corporate decision making.)
And so we should all be interested in the Goldilocks question posed above: Is the current market valuation of US stocks too high, too low, or just about right?
The WSJ recently published on the same day two separate articles which addressed this question (links below). In a sign of truly independent journalism perhaps, the authors of these two articles examined the data and came to completely opposite conclusions. One author concluded that “stocks have never been this expensive” and the other that “the stock market hasn’t looked this cheap in years”.
More importantly, however, investors and corporate executives are having exactly this same debate, in real time, and the answers they come up (unlike those of the WSJ writers) with will likely impact the capital markets and the real economy for months and possibly years to come. As will the decisions of various government policymakers, most notably the Fed.
It is important that we all be prepared to participate in this debate, with our minds if not our money, and so I encourage you all to read both of these articles and begin to form your own views.
Links:
The Trouble with a Stock Market Bubble, WSJ 2.11.2022
The Stock Market Has not Looked This Cheap in Years, 2.11.2022