Can Lofty US Stock Market Valuations Be Safely Ignored?
Bullish expectations for earnings growth, if correct, could act as a counterweight to high valuation and keep the equity market humming, but high valuations for stocks is still a risk factor.
By James Picerno | The Milwaukee Company | jpicerno@themilwaukeecompany.com
The belief that “it’s different this time” often leads to trouble in investing, but so far the US stock market continues to defy gravity, based on several metrics that attempt to estimate valuation for American shares. The persistent rise in US equities is helping promote a view that the relationships of old for stocks and traditional measures for value-oriented investing strategies no longer apply.
One line of reasoning that argues the times have changed says that earnings growth will continue to support relatively high valuations and keep the party going for longer than expected. Fueled by increased spending on technology (including artificial intelligence), the business outlook remains robust. In turn, this alleged virtuous cycle is lifting expectations for corporate earnings, argue the optimists.
Recent updates seem to align with this sunny outlook. FactSet, for example, last week reported that its current estimate for blended earnings growth for S&P 500 companies in Q4 2024 rose 16.4% vs. the year-ago level. If that holds up for the final tally, it will mark the best year-over-year comparison for earnings in three years.
Supporting the case for expecting the market to continue rising on the back of improving fundamentals is the recent uptrend in share prices, which has lifted the S&P 500 Index more than 23% over the past year. The bulls are quick to note that a large body of evidence suggests that recent trend behavior tends to persist in the short term.
But after more than two years of a mostly steady rise in US stocks, investors with longer-term time horizons are cautiously eyeing market valuations that, by historical standards, look unusually high. Professor Robert Shiller’s CAPE Ratio (cyclically adjusted price-to-earnings ratio) is currently tied with mid-2021 for posting the second-highest valuation level in more than a century – a level that implies substantially lower returns for stocks in the medium-to-long run future vs. recent history.
A variation on the CAPE Ratio that adjusts the metric using real (inflation-adjusted) yields for an arguably superior modeling exercise implies that investors should dramatically reduce expectations for S&P 500 returns for the years ahead. The S&P’s so-called excess return over inflation is currently 12.5% for the trailing ten-year period – far above the Excess CAPE Yield (ECY) model’s current return forecast of just 1.3% for the decade ahead.
Several other valuation-based models also project relatively modest performance results for the years ahead compared with the past decade. But there are caveats to keep in mind, starting with the empirical observation that valuation-based forecasts have been crying wolf for several years while the market has continued to run higher. That highlights the view that valuation-based forecasts tend to be more useful as a starting point for adjusting asset allocation rather than as a tool for timing the short-term moves in equities. On that basis, the ECY model lays the groundwork for rebalancing US equity weights down in some degree.
Another caveat is the possibility that the rise of tech (and more recently AI) is genuinely driving a structural shift in the economy and one that will deliver a golden age of growth that supports relatively high market valuations. No one can rule out that possibility, but students of market history will rightly counter that animal spirits are still likely to swing from one extreme to another no matter the macro regime. Technology may be improving, but investor sentiment writ large is still vulnerable to the usual foibles. It certainly seems that a new world order of AI may be dawning, and one that reinvents the business and consumer sectors. But assuming that markets will no longer overshoot and undershoot is probably a step too far.
On that basis, a cautious outlook for stocks is an incentive for a calculated-risk decision that hedges allocations is US shares, especially in portfolios that hold American equities at substantially above-target weights. Forecasts of a future “growth explosion” may be reasonable, perhaps even likely, but there’s still no basis for thinking that animal spirits won’t again be a contributing factor that leads to a new bear market at some point.
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Maybe I am mis-reading the analysis, but I thought Shiller's CAPE was already real, i.e., adjusted for inflation.