Are US stocks overvalued? It’s among the leading question I’m receiving, along with whether candidate X or Y, if (re)elected, will tank the market. The answer to the latter, viewed through history’s lens, is a resounding no. In assessing if stocks are currently overvalued however, we find a classic Rorschach test, in that you can see what you want to see.
On an absolute basis, across different valuations metrics—price to earnings, price to sales, cyclically adjusted price to earnings (CAPE), market capitalization as a percent of Gross Domestic Product, and others—US equities, as represented by the S&P 500 Index, appear overvalued.1 On a relative basis, that’s not the case. Stocks, given today’s low interest rate environment, are trading as cheap to bonds as ever. For every dollar invested in the broad US equity market, companies are earning 4.4%.2 Every dollar invested in a 10-year US Treasury rate yields roughly 0.5%.3 Seen through that lens, it’s hard to make the case that equities aren’t attractive. Low interest rates tend to be supportive for equity multiples, as they inflate the value of future cash flow and tend to push equity market multiples higher.
However, even if you agree with that premise, you may still need support to ease concerns about absolute valuations. In the accompanying paper, we attempt to provide the truths about current valuations. Our findings are as follows:
- Valuations are bad timing tools. The relationship between valuations and 1-, 3-, and 5-year forward returns is statistically insignificant.4 In short, knowing that something is “cheap” or “expensive” tells you very little about short- to intermediate-term returns. Instead, in my view, investors should look for catalysts, be it a change in the macroeconomic growth trajectory or a new monetary policy direction, to assess the future direction of the market.
- Equity valuations almost always appear elevated in the immediate aftermath of recessions. It makes perfect sense, given that stocks are leading indicators and tend to bottom in recessions and retrace higher well before the economy and earnings recover. In fact, the peak price to earnings ratio of the S&P 500 Index was even higher following each of the past three recessions (26.8x in May 1992, 27.8x in February 2003, 24.2x in November 2009) than it is today.5 Stocks returned, on average, 13.5% in the 5-years following the post-recession peak in the price to earnings ratio.6 In short, stocks tend to “grow into their multiples” as earnings improve in new economic cycles.
- A large percentage of the broad US equity market is still trading well below February 2020 levels.7 Catalysts, such as improving growth and/or higher inflation, would likely be required to unlock some of that “value” in the market. For all the handwringing about the performance of the top five names in the market, it is important to note that those businesses have generated 4x the revenue growth and 4x the earnings growth of the broad market over the past decade.8 In short, investors are paying “fancy” multiples for companies that have largely delivered.
- Comparisons to the late 1990s tech rally are prevalent but not necessarily fitting. In 1999, the median price to sales of the top 10 largest NASDAQ companies by market capitalization was 21.9x. Currently, it is elevated at 8.1x, but meaningfully below that reached at the height of the tech bubble. 9 For their part, the so-called FAANG (Facebook, Apple, Amazon, Netflix, Google) stocks are trading at an average price to sales of 5.9x, compared to a 1990s tech portfolio of Intel, Cisco, Microsoft, Oracle, EMC2, which traded at a peak average price to sales of 16x. 10 Admittedly, the relative performance of the FAANGs over the past five years is tracking that of companies such as Intel, Cisco, Microsoft, Oracle, and EMC² in the 1990s but is not yet near the extreme levels ultimately reached.
- Valuations are more attractive outside the US, as has been the case for years. Both developed market equities excluding the US, and emerging market equities are trading at only modest premiums to their long-term averages.11 Canadian stocks, for their part, are trading at a discount to their long-term price to sales average that is slightly wider than that of emerging market equities.12 Again, there needs to be a catalyst to unlock the value found in the developed (excluding US) and emerging markets. A weaker US dollar and improving global economic activity could be the impetus for investors to begin searching for opportunities outside the US.
So, are stocks overvalued? It may be a mixed picture but perhaps not as extreme as many investors may suspect. With interest rates low and expected to remain low in what will be a persistently slow growth world, there appears to be few alternatives to equities. With apologies to Madonna, we are likely living in a relative world. And I am a relative boy.
1 Source: Bloomberg, 7/31/2020.
2 Source: Bloomberg. As represented by the S&P 500 Index, 7/31/2020.
3 Source: Bloomberg. As represented by the 10-year US Treasury Rate, 7/31/2020.
4 Source: Bloomberg. Based on a regression of Historical S&P 500 P/E Ratios and subsequent 10-year returns, from 1957 to June 2020.
5 Source: Bloomberg. As represented by the S&P 500 Index, 7/31/2020.
6 Source: Bloomberg. As represented by the S&P 500 Index, 7/31/2020.
7 Source: Bloomberg. As represented by the S&P 500 Index, 7/31/2020.
8 Source: Bloomberg. As represented by the S&P 500 Index, 7/31/2020. The five largest companies by market capitalization in the S&P 500 Index are Apple, Microsoft, Amazon, Facebook, and Alphabet.
9 Source: Bloomberg, 7/31/2020.
10 Source: FactSet, 6/30/2020. The mention of specific companies does not constitute a recommendation on behalf of any fund or Invesco. (1) FAANG Relative is a hypothetical portfolio including Facebook, Amazon, Apple, Netflix, and Google. (2) Tech Bubble Relative is a hypothetical portfolio including Intel, Cisco, Microsoft, Oracle, and EMC. Returns are total returns relative to the S&P 500 index total returns. Past performance does not guarantee future results.
11 Source: Haver 6/30/2020. As represented by the MSCI World Index and MSCI Emerging Markets Index.
12 Source: Haver 6/30/2020. As represented by the MSCI Canada Index
Blog Header Image: Jose Fulgencio / Unsplash
The price to earnings ratio is calculated by diving a company’s share price by earnings per share (EPS)
The price to sales ratio is calculated by dividing a company’s share price by revenue.
The cyclically adjusted price to earnings, CAPE, measures earnings per share over a 10-year period to account for fluctuations in corporate profits during a normal business cycle.
The MSCI Emerging Markets Index captures large- and mid-cap representation across 26 Emerging Markets (EM) countries. With 1,198 constituents, the index covers approximately 85% of the free-float-adjusted market capitalization in each country.
The MSCI All Country World Index is an unmanaged index considered representative of large- and mid-cap stocks across developed and emerging markets.
The MSCI Canada Index measures the performance of the large- and mid-cap segments of the Canadian market.
The opinions referenced above are those of the author as of August 26, 2020. These comments should not be construed as recommendations, but as an illustration of broader themes. Forward-looking statements are not guarantees of future results. They involve risks, uncertainties and assumptions; there can be no assurance that actual results will not differ materially from expectations.
In general, stock values fluctuate, sometimes widely, in response to activities specific to the company as well as general market, economic and political conditions.
The risks of investing in securities of foreign issuers, including emerging market issuers, can include fluctuations in foreign currencies, political and economic instability, and foreign taxation issues.