Yes, stocks are expensive. Most everyone along Wall Street agrees on that following their amazing return to records despite the still-raging pandemic.
But whether that’s something to worry about? Another question entirely.
Analysts have many ways to measure whether a stock is over- or under-valued, rather than simply looking at its price. Because stocks tend to move with corporate profits over the long term, one favoured method is to divide a stock’s price by how much profit per share the company made over the prior 12 months. The higher that number is, the more expensive — and less attractive — the stock is.
By that measure, the S&P 500 this month hit its most expensive level since late 2000, shortly after the dot-com bubble burst.
The index also looks pricey by other measures. Compared to what analysts are forecasting for its earnings in the upcoming 12 months, the S&P 500 earlier this month also was at its highest level since 2000.
A third measuring stick, popularized by Nobel prize-winning economist Robert Shiller at Yale University, says the S&P 500 was recently trading at more than 30 times its average earnings over the last 10 years, adjusted for inflation. That’s above its average of 26.1 over the last decade or of 20.5 over the last 50 years.
High valuations are nothing new, when seen through the lens of what’s often called the “Buffett indicator,” which is named after famed value investor Warren Buffett and looks at the total market value of stocks relative to the overall size of the economy. It’s been higher than the U.S. gross domestic product from 2010 onward.
The argument for being worried about such numbers is simple: When stock prices are high, compared with corporate profits, they leave little room for error and mean stocks may not be worth their price tags. Such worries got some validation in recent weeks after stocks with some of the highest valuations — technology stocks — slumped sharply for no clear reason.
Global fund managers rank another tech bubble as the No. 2 risk that could swamp investments, just after a second wave of coronavirus infections, according to the most recent monthly survey by BofA Global Research.
The argument for being OK with high valuations is more nuanced. Stocks have climbed this high on expectations that profits and the economy will resume growing after a vaccine for the new coronavirus hits the market. That may come as early as the first three months of 2021, according to many investors.
Also, interest rates have almost never been this low before. The Federal Reserve has said it will keep short-term rates pinned at nearly zero for a while to help the economy recover, and it may even wait to raise rates until after inflation rises above its target level. On Wednesday, it voted again not to touch short-term rates.
Lower interest rates generally mean higher valuations for stocks. For one, it means bonds are paying less in interest, which makes them relatively less appealing than stocks. It also means the future cash flows that companies are expected to generate are worth more in today’s dollars than they would have been if interest rates were higher.
That’s part of the reason why Goldman Sachs strategists say the S&P 500 could end the year at 3,600, a nearly 6% rise from Tuesday’s close, although they acknowledge today’s valuations are already high.
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