The stock market is not just expensive; it is extremely pricey. Despite this, historical data suggests that it has the potential to deliver impressive gains from its current level.
Current Market Situation
The S&P 500 has witnessed a nearly 15% increase so far this year. This rise can be attributed to increasing investor expectations that the Federal Reserve will refrain from further interest-rate hikes. These hikes are intended to cool down the economy but have a negative impact on stocks. The decline in the rate of inflation has further boosted investor confidence. Additionally, the surge in Big Tech stocks can be attributed to the optimism surrounding the potential of artificial intelligence to enhance existing products and create new opportunities.
The Costly Nature of Stocks
Currently, the S&P 500 is trading at approximately 18 times the aggregate earnings per share projected for its component companies over the next 12 months. This valuation is well above the historical average of around 15 times. However, this metric fails to fully capture the extent to which stocks have become expensive when considering that the ratio has remained above 20 during extended periods in the past.
The valuation of stocks is closely linked to the level of interest rates. With the index trading at 18 times earnings, an investor can expect an annual per-share profit of around $5.50 for every $100 invested.
Significantly, this return of 5.5% is only 1 percentage point higher than the approximate 4.5% yield offered by holding safe 10-year Treasury debt. Known as the equity risk premium, this additional return is currently at a 20-year low. It is far below the long-term average of approximately 3 percentage points, as reported by Morgan Stanley.
If the equity risk premium were at its historical average level, the earnings yield on the S&P 500 would be 7.5%. This suggests that the index should trade at just 13.3 times earnings, which is significantly lower than the current valuation of 18 times. This indicates that the stock market is currently overpriced.
Despite the current expensive valuation, historical data reveals that when the equity risk premium is as low as it is presently, stocks have tended to rise by double digits over the following year. For instance, when the equity risk premium on the S&P 500 falls between zero and 1%, the average gain for the following year is slightly above 12%, according to RBC.
In conclusion, while the stock market's valuation may be alarmingly high, historical trends suggest that it has the potential for substantial gains when the equity risk premium reaches such low levels. These observations provide valuable insights for investors navigating the current market landscape.
Reasons for Buying Stocks Despite Negative Equity Risk Premium
It is when the equity risk premium is negative, with stocks yielding less than the S&P 500, that the index goes on to decline in the following year.
Contrary to the aforementioned scenario, the current market situation presents several reasons why individuals would still consider investing in stocks, even with a narrow equity risk premium.
Confidence in Higher Earnings
Today, the market exudes confidence that earnings over the next couple of years will surpass Wall Street predictions. Recent trends have supported this belief, as the economy has continued to grow despite concerns that the Federal Reserve's actions against inflation could trigger a recession. This positive development has helped companies exceed analysts' estimates, further boosting optimism. Additionally, Big Tech is expected to deliver double-digit annual EPS growth in the upcoming years.
Potential for Earnings Forecast Upgrades
Given the likelihood of the above-mentioned favorable scenario, analysts are anticipated to revise their earnings forecasts accordingly. If stock prices remain stable, this would result in a lower forward price/earnings multiple for the S&P 500, making the market appear less expensive.
Rising Earnings Yield and Potential Decline in Bond Yields
As the equity-risk premium increases, the earnings yield is expected to rise while bond yields may decrease. In fact, the 10-year yield has already dropped by approximately half a percentage point from its peak in October. Furthermore, projections indicate that the average annual rate of inflation over the next decade will be around 2%, suggesting a potential decline in bond yields.
Favorable Market Conditions
According to Sevens Report's Tom Essaye, the downward movement of the 10-year yield is expected to continue, acting as a catalyst for stocks. In response to this promising outlook, investors are already strategizing how best to position themselves. Lori Calvasina, RBC's chief U.S. equity strategist, highlighted how clients are exploring stock options in preparation for potential declining yields.
Despite the negative equity risk premium, there are compelling reasons why stocks could rally and continue their upward trajectory. With confidence in higher earnings, the possibility of earnings forecast upgrades, and favorable market conditions, investing in stocks remains a reasonable expectation.