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Investors can agree on at least one thing: The stock market is expensive. The thornier issue is how they should respond.

The stock market has made a remarkable recovery since March, 2020, as many brave investors bet that ultralow interest rates and massive stimulus from governments and central banks would unleash a spectacular economic recovery – and boost corporate profits. So far, that bet has worked out.

The Standard & Poor’s 500 Index is now 28 per cent above its high in early 2020, before the COVID-19 pandemic wreaked havoc on the economy and stock market.

Reaching a peak: The economic rebound is topping out, and stocks are at risk

It’s not the only index still surging on optimism. Canada’s S&P/TSX Composite Index and Germany’s DAX are both 12 per cent higher than they were in early 2020, while Japan’s Nikkei 225 is up 17 per cent over a similar period.

But the gains have run ahead of the recovery in corporate profits, leaving stocks – by some measures – at their most expensive since the technology bubble of the 1990s, which burst in 2000.

According to Connecticut-based Birinyi Associates, the S&P 500 is now trading at about 30.5 times trailing 12-month earnings, edging above the previous record high price-to-earnings ratio of 29.3 in 1999. The average since 1960 is just 16.4, according to Bank of America.

But today’s lofty trailing P/E ratio includes the decimated profits of 2020, creating some distortions in this valuation measure.

Even so, the forward P/E ratio, using analysts’ upbeat profit estimates for the next 12 months, is also in nosebleed territory. Birinyi Associates says the forward P/E is currently 22.6 – shy of the 1990s tech bubble, but well above the historical average of 15.5.

And using average profits over a business cycle, the CAPE ratio (or the cyclically adjusted P/E ratio, developed by Yale University finance professor Robert Shiller) is 37. That’s the highest reading for this measure since 1999, when it topped out at 44.2.

“Valuation is certainly not cheap,” Tobias Levkovich, chief U.S. equity strategist at Citigroup, said in an interview.

What should investors do? Pull back on stocks or ignore the warning signs?

In some sectors, such as consumer discretionary and information technology, valuations can look particularly egregious.

Nike Inc. trades at 38 times estimated earnings. Amazon.com Inc. trades at 61 times estimated earnings. And Ottawa-based Shopify Inc., Canada’s most valuable company based on the value of its outstanding shares, trades at more than 400 times estimated forward earnings, according to Bloomberg, and about 48 times its reported sales.

The strong economic recovery now unfolding can provide only so much justification, according to Mr. Levkovich. While the Roaring Twenties of the past century offer a tempting comparison to today’s recovery, the scale of deprivation is not the same.

Before the 1920s, consumers were deprived for several years during the First World War and the 1918 Spanish flu outbreak. By comparison, COVID-19 lockdowns have stretched just 15 months, and flush consumers have still been able to buy TVs, clothes and lots of other items online while cooped up at home. The economic jolt from travelling again and going out to restaurants could extend into 2022, Mr. Levkovich said, but not 2025.

“The 1920s comparison period is really, really wrong,” he said.

So how worried should investors be?

There are plenty of reasons to stay calm. For one, many analysts and portfolio managers believe valuations are a terrible market timing tool, at least in the near term.

Michael Kantrowitz, chief investment strategist at Cornerstone Macro, looked at various valuation measures – including P/E ratios and CAPE – and found essentially no correlation with returns over 12-month periods.

“Valuation, in our view, is always a condition and not a catalyst. In other words, stocks don’t fall because they are expensive, nor do they rise because they are cheap,” Mr. Kantrowitz said in a note.

As well, there are few attractive alternatives to stocks right now.

Investment returns in the first half of 2021 underscored this point. The S&P 500 delivered a total return (including dividends) of 15.2 per cent over the past six months.

Compare that with the lacklustre returns from long-term U.S. Treasury bonds (down 7.5 per cent) and gold (down 6.8 per cent) over the same period, and you can see why riding an expensive stock market rally can be appealing.

Nonetheless, experts are not complacent right now.

Richard Bernstein, a former Wall Street strategist who called the tech bubble and now leads Richard Bernstein Advisors, believes a handful of market characteristics suggest another bubble is forming. For example, the use of leverage to buy stocks is rising, interest among individual investors is soaring and there is a deluge of new issues, including SPACs (special purpose acquisition companies).

However, rather than avoiding stocks altogether, Mr. Bernstein is focusing on relatively cheap sectors such as energy, materials, financials and industrials, along with non-U.S. markets.

Strategists at BlackRock, the world’s largest asset manager, are increasing their weighting of European stocks, which have been slower than companies in North America to recover from lockdowns.

Bank of America strategists recommend looking at Canada. The S&P/TSX Composite Index has a P/E ratio of 17 times forward earnings, according to the bank’s numbers, offering the biggest discount to the S&P 500 since the tech bubble.

“We believe the discount is overdone, especially when the composition of the TSX is much better positioned to benefit from the global economic recovery,” Ohsung Kwon and Savita Subramanian, equity and quant strategists at Bank of America, said in a report.

Still, with the Canadian benchmark up nearly 69 per cent from its lows last year, you have to put this opportunity into perspective: Canadian stocks may be cheaper than U.S. ones, but they’re not exactly cheap.

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