investment viewpoints

How expensive is the US equity market?

How expensive is the US equity market?
Florian Ielpo, PhD - Head of Macro, Multi asset

Florian Ielpo, PhD

Head of Macro, Multi asset
Pascal Menges - CLIC Equities, CIO Office

Pascal Menges

CLIC Equities, CIO Office

Regardless of whether investors currently have a bearish or bullish view on equities, the big question concerns valuations. Our latest edition of Simply put considers whether US equities are prohibitively expensive at the moment.

 

Need to know:

  • The S&P500 looks very expensive at first sight, given the recent rally
  • Markets currently anticipate stable earnings and rates hovering around 4%, meaning the S&P500 can look up to 40% overvalued
  • However, a different picture emerges depending on projected economic scenarios and the current share of large caps. Only a large recession would actually make this expensiveness prohibitive and smaller caps could suffer less under such a scenario

 

A good year for equities

This year has so far been very good for equities against a backdrop of a widely anticipated recession. Many regional equities have undergone a 20% or more rally, year to date, even climbing to around 30% for the Nasdaq. Comparatively, bottom to peak, developed market (DM) equities had rallied by 13% in 2007 and nearly 15% over Q2 2008, but nothing in comparison with today. 

There are many explanations for this recent performance, among of which are a bearish mood and low equity positioning in December last year. Now that sentiment and positioning have by-and-large normalised (the large amount of cash on the side-lines probably owes more to duration than to equities now) has the moment come to worry about valuations? If we focus on the emblematic S&P500, is it fair to say that it is now too expensive?
 

Gauging valuations

There are two general methods to gauge valuations from a quantitative perspective. The first is based on corporate finance models, while the second is based on econometric regressions. 

The corporate finance version uses discount factor models to relate the growth rate of dividends to the Weight Average Cost of Capital (WACC) - a measure of the funding rates a group of companies are exposed to. Both these components are subject to various interpretations, and therefore values, making an econometric approach appealing as it allows for an (economic) model-free empirical relationship between stock prices and their agreed-upon fundamentals. 

The most obvious two key ingredients for an econometric model are 10-year yields and corporate profits. Figure 1 demonstrates their importance by showing first the ratio between the S&P500 and profits and comparing it to the inverted 10-year yield. The red line clearly shows the bubble period of 2001, the cheapness of stocks over the 2012-2017 period and finally highlights how prices today have reached elevated levels, on a historical basis. Having higher rates such as during the 1970s weighs on valuations while today’s lower rates can be seen to help the ratio of prices to profit gain some altitude. This is an interesting observation but not a straight answer to the question of the day: how expensive is the S&P500 today?
 

Figure 1. S&P500 price to profits ratio vs. inverted 10-year Treasury yield

Source: Bloomberg, LOIM.

 

The S&P500 is probably 40% overvalued

Figure 2 shows the fitted values that comes from running the regression of the (log) S&P500 price on (log) profits and 10-year rates. The residuals of that regression are shown as a histogram on the same chart. Those residuals would fail a stationarity test, as the 2001 bubble created a non-stationarity in the sample. However, this does not prevent us from using this long-run regression to diagnose the current expensiveness of US equities. The outcome of that regression is the following:

  • The fundamental value of the S&P500 should sit at around the 3600 points level
  • This means that US equities are probably about 40% overvalued given the latest earnings progression

The last part of this second point is essential: this econometric valuation relies on the last known values of the two key ingredients: rates and profits. From that perspective, equities are extremely expensive but not in bubble territory, as was the case in 2001. 
 

Figure 2. Log S&P500 vs. fit and residuals from the econometric model

Source: Bloomberg, LOIM.

 

Perspective matters…

Even if today’s given inputs make the S&P500 look expensive, this does not mean that the answer to our question is a straightforward “yes, it is too expensive”. It also depends on the future direction of rates and earnings. Table 1 below gives an idea of a fundamental valuation for US stocks as a function of an input scenario. Markets currently expect earnings over Q3 to stop progressing  while 10-year yields are expected to fall back around the 3.5% level. Within that scenario, the S&P500 is 42% overvalued. However, other scenarios are also possible:

  • Earnings remain steady while inflation declines, leading rates to fall to 2.5%. Under such circumstances, US stocks would only be 34% overvalued
  • Earnings could gain, given the recent macro improvements, while rates remain at 4%. With 10% earnings growth, equities would now be only 31% over-valued (which can last for months as shown on Figure 2)
  • Earnings could decline by 15% while rates fall to 2%. Within that recession scenario, the S&P500 would be about 56% overvalued

The key point here is to highlight that US equities are expensive – who could argue with that – but this situation can be interpreted in various ways, depending on the outlook. Only a genuine deflationary recession would make the current valuation of the S&P500 prohibitive. 
 

Table 1. Fundamental valuation of the S&P500 as a function of earnings and rates

Source: Bloomberg, LOIM.

 

… as well as the composition of the index

Of an equal importance is the current composition of the S&P500 index. Much has already been written on this topic, but the current share of the first five capitalisations in the index largely contributes to this overall impression of expensiveness. 

Figure 4 shows one interesting piece of evidence on that front : when comparing the price-earnings (PE) of the equally weighted S&P500 to the index itself, a unique pattern appears. Both indices have long been showing roughly the same PE ratio, with even the equi-weighted index trading at a premium versus the index itself. It’s only recently that this situation has reversed: today, the S&P500 index’s PE is about 15% higher than the equi-weighted index, with the latter now trading at a sharp discount – pretty much the opposite to the situation in 2011. The apparent expensiveness of the index therefore hides a large valuation unevenness which probably ties to the recent AI frenzy.
 

Figure 4. PE of the S&P500 index compared with its equally-weighted version (left) and ratio of PEs between these two indices (right)

Source: Bloomberg, LOIM.
 

Simply put, the S&P500 looks expensive, but the question of whether it is too expensive depends largely on whether a recession is likely. The index’s composition, and a potential improvement in earnings, could help justify current valuations. 

 

 


Macro/nowcasting corner

This section gathers the most recent evolution of our proprietary nowcasting indicators for world growth, world inflation surprises and world monetary-policy surprises. These indicators keep track of the most recent macro evolutions that make markets tick.

Our nowcasting indicators currently point to:

  • Consistently with last weeks’ diffusion index recovery, the US growth nowcaster has increased by 5%, with now more than 60% of improving data. Growth is now low and rising
  • Inflation’s diffusion index is also higher now with 68% of improving data, but the nowcaster itself is not moving much for the moment: inflation low but improving
  • Monetary policy should remain neutral in our macro scoring at the moment and remained broadly unchanged this week

 

World growth nowcaster: long-term (left) and recent evolution (right)

World inflation nowcaster: long-term (left) and recent evolution (right)

World monetary policy nowcaster: long-term (left) and recent evolution (right)

LOIM’s nowcasting indicator gather economic indicators in a point-in-time manner in order to measure the likelihood of a given macro risk – growth, inflation surprises and monetary policy surprises. The Nowcaster varies between 0% (low growth, low inflation surprises and dovish monetary policy) and 100% (the high growth, high inflation surprises and hawkish monetary policy). 

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