The U.S. stock market looks insanely expensive. Indeed, rising stock prices and lower earnings forecasts have pushed the S&P 500’s forward 12-month P/E ratio to 21.9 .
This widely followed measure is now well above its five-year average of 16.9 and its 10-year average of 15.2. The forward P/E hasn’t been that high in at least 18 years and is close to the record 24.4 on March 24, 2000, when the dotcom bubble was about to implode.
While the stock market looks incredibly expensive, many reasons can explain this high valuation.
Low interest rates and other forms of monetary stimulus seem to justify higher market valuations.
The Federal Reserve cut rates to zero and launched an open-ended quantitative easing program to support the economy amid the pandemic.
The U.S. central bank also launched a series of programs to help small- and medium-sized businesses and started buying individual corporate bonds .
Stocks are more attractive as bond yields are very low.
Stock multiples have increased dramatically over the past year from 16.6x to 21.7x today. At the same time, 10-year Treasury yields and investment-grade corporate bond yields have collapsed from 2.1% to 0.7%, and 4.5% to 3.6%. Not surprisingly, investors are making the case that current, elevated stock valuations are justified given the collapse in rates.
Recent economic data have been surprisingly good. Key indicators such as retail sales and payrolls have increased by much more than any economist could have expected last month.
Retail sales rose 17.7% in May , more than double what economists predicted. That’s the biggest monthly gain on record.
Unemployment in the United States unexpectedly fell from 14.7% in April to 13.3% in May . Nonfarm payrolls rose by 2.5 million after a record drop of 20.7 million in April.
These data suggest the economy is in better shape than previously thought, at least in the short term. Better-than-expected economic numbers have contributed to strengthening investors’ optimism about a sharp recovery, adding fuel to the stock market rally.
Dramatic surges in big-tech stocks like Amazon (NASDAQ:AMZN) and Netflix (NASDAQ:NFLX), which are up more than 40% since the start of the year, have boosted the S&P 500.
Amazon saw a massive surge in online shopping, while Netflix had a record number of new subscriptions as people were confined to their homes.
The Nasdaq, which is heavily weighted in tech stocks, is up by 12% this year. The S&P 500 and the Dow Jones are still in the red. Tech stocks generally have better prospects for earnings growth, so they have higher P/Es.
The stock market seems to be pricing in a fast recovery. But many risks could send equities lower.
John Normand, head of cross-asset fundamental strategy at JPMorgan, has identified six “wildcards ” that could derail the stock market rally: a second significant wave; the expiration of temporary fiscal stimulus measures; the end of monetary stimulus; U.S. sanctions against China “before November to increase Trump’s rating or after November on Trump’s re-election;” a U.S. electoral result which leads to increases in corporate tax; and a hard Brexit.
According to billionaire investor Howard Marks , the risk of decline outweighs the potential for further gains:
As such, it seems to me that the potential for further gains from things turning out better than expected or valuations continuing to expand doesn’t fully compensate for the risk of decline from events disappointing or multiples contracting. In other words, the fundamental outlook may be positive on balance, but with listed security prices where they are, the odds aren’t in investors’ favor.
There is another cause for concern. RBC’s data show that the market tends to go down over the next 12 months when valuations are that high.
So, while high valuations don’t seem to matter now, the stock market won’t stay at those high levels forever. A big bubble is forming and could pop anytime.