Stocks in the United States have made a remarkable rebound from pandemic-driven lows last spring. As measured by the S&P 500® Index, they gained 75% between March 23, 2020, and Feb. 19, 2021. Massive injections of both fiscal and monetary stimulus facilitated the rebound and helped stabilize the economy. That created an exceptionally favorable backdrop for stocks. So favorable that by the start of this year, stock valuations were beginning to look expensive.
Contributing to the rise in valuations was the fact that while stock prices were rising, corporate earnings were falling. That pushed the price of stocks compared to their most recent 12 months of earnings, or P/E ratio, to a level exceeded only a handful of times in the past.
But investors were unfazed. They looked through the pandemic toward an expected economic recovery, and, along with it, a recovery in earnings. And indeed, earnings are expected to rebound strongly this year as the economy reopens — to be followed by another year of estimated double-digit growth in 2022.
However, even accounting for this expected earnings growth, stocks appear expensive. And they look even more so compared to top-line growth, or sales. Other measures of intrinsic value show the same phenomenon, such as comparing:
- Stock prices to net assets or book value
- The aggregate value of the stock market to two measures of U.S. economic activity: gross domestic product and gross domestic income
Another way to measure the relative attractiveness of stock prices is through sentiment indicators, or the relative degree of investor optimism. They, too, are signaling elevated levels of bullishness. For example:
- The ratio of bullish to bearish investment newsletters is near the upper end of its historical range.
- Surveys of individual investors are elevated, although not at extremes.
- The ratio of bullish call option buying to bearish put buying is at its highest in 20 years.
- The pace of weekly inflows into global equity funds recently reached a record high.
The one basis on which stock prices had looked reasonable was in comparison to bonds. Bond yields had risen modestly since the summer but remained historically low. This offered investors portfolio diversification but little competition for the return potential of stocks.
More recently, however, bonds have become relatively more attractive. The yield on the U.S. 10-year Treasury note has climbed sharply, rising from 0.91% at the start of the year to 1.50% as of Feb. 25. As a result, the start-of-the-year 0.67% dividend yield advantage of the S&P 500 versus the 10-year note yield has virtually disappeared. And higher interest rates put pressure stock prices.
Implications of high valuations
High stock valuation and sentiment indicators could mean that further upside may be limited. Given prices may already reflect the prevailing high level of optimism, that leaves investors with fewer bulls to buy.
This could increase the potential for a market correction, as investors consider booking their profits. Market corrections often serve to relieve excesses in the market, as prices reset closer to their intrinsic value. In doing so, corrections can help extend the duration of market expansions.
Corrections do not inevitably lead to bear markets, defined as a decline of at least 20% among stock prices. Bear markets have occurred about every 4.5 years, on average, over the past 90 years. Market corrections, defined as declines of between 10% to 20%, occur about every two years, on average. Over the past 50 years, about 20% of market corrections have led to bear markets.
For those reasons, it is important for long-term investors to remember that it can be counterproductive to sell out of stocks in these conditions for two main reasons.
- Valuations can stay elevated for long periods of time while markets continue to climb.
- Markets often rebound following corrections, as asset values become more attractively priced. Trying to successfully time when to sell and when to buy back in is difficult at best.
High valuation and sentiment indicators may signal that we are getting closer to the next market correction, but exactly when is impossible to say. However, we believe the current uptrend in the market has a good chance to continue. Monetary and fiscal policy remain exceedingly supportive, vaccines are being distributed, corporate earnings are growing and consumer balance sheets remain generally healthy.
As the economy moves closer to reopening, consumers are prepared to satisfy a backlog of pent-up demand. In our view, long-term investors navigating these conditions should continue forward with a balanced, diversified portfolio designed to support their financial goals.