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The S&P 500's Current Valuation Is (Still) Quite Fair. Here's Why.

Motley Fool - Sun Oct 29, 2023

The market hasn't exactly been firing on all cylinders recently. As of the latest look, the S&P 500(SNPINDEX: ^GSPC) is down 8% from its late-July peak, mostly on fears that persistent inflation will push the world into a recession. And maybe it will.

We're now into the third quarter's earnings season with all of September's economic reports in hand, however, and so far the numbers aren't too bad. They're pretty good, in fact, with the analyst community still calling for earnings growth rather than an earnings contraction. This leaves the market's past and projected valuation in line with long-term norms.

Translation: You may want to stick with your stocks right now if you've been thinking about an exit here. Or, if you're already out, you might want to use the recent sell-off as a reentry opportunity.

By the numbers

Cutting straight to the chase, the S&P 500 is currently valued at 20.2 times its trailing per-share profits, and right around 18.1 times its 12-month earnings projections. Both numbers are below their respective 10-year average price-to-earnings ratios, albeit just barely.

Chart showing the S&P 500's current trailing and projected price/earnings ratio.

Data source: Standard & Poor's. Chart by author.

Surprised? The explanation is simple enough -- earnings are growing rather than falling. The S&P 500's earnings are projected to roll in at $54.82 per share for the third quarter, up 8.8% from its collective bottom line from the same quarter a year earlier, en route to new record levels next year.

Chart showing the S&P 500's historical and projected earnings.

Data source: Standard & Poor's. Chart by author.

There's no fortuitous accounting causing artificially elevated profitability levels, either. All sectors are turning about as much of their revenue into net income as they normally would (although the energy sector is doing measurably better than its average in this regard, thanks to frothy oil prices). All told, 11.8% of the S&P 500's third-quarter revenue is expected to become net income, in line with long-term norms.

This reality doesn't exactly jibe with the prevailing narrative, does it? Consumers are supposed to be buckling under the weight of rampant inflation. For-profit corporations are presumed to be struggling with sky-high borrowing costs. Everyone's supposed to be unable to cope with this challenging economy. Ergo, stocks are supposed to be dangerously overvalued.

Except... they're not.

It's a bigger-picture, forward-looking kind of thing

There is one reasonable argument that the S&P 500's trailing and forward-looking price-to-earnings ratios are still too frothy at their current levels. That's interest rates.

See, the market tends to support steeper valuations when interest rates are low and borrowing is cheap, which was the case for years between 2008's subprime mortgage meltdown and 2022's end to the COVID-19 pandemic. Conversely, when interest rates reach multiyear highs as they have this year, valuations could be expected to slump. That's because the reward for holding fixed-income investments like Treasury bonds and bills is higher in these environments, so the relative attractiveness in holding stocks is lowered. That means valuation figures could -- and some say should -- contract.

Be careful when it comes to making decisions based on such valuation models, though. They're complex, and yet incomplete in that they don't consider and then quantify every factor that might impact a stock's or a broad market's fair valuation. More often than not a simpler approach to stock-picking is a superior solution if only because it's easier to implement and maintain.

In other words, don't get bogged down by details that may or may not matter. Rather, take note of the fact that earnings have been consistently rising since last year, and are expected to continue growing at least through 2024 against a backdrop of waning inflation. That dials back much of any risk linked to excessive valuations.

That's according to JPMorgan Chase's U.S. Head of Investment Strategy Jacob Manoukian, anyway. He noted in early October: "Earnings expectations are still climbing, while the drawdown has brought valuations back in line with the 10-year average level. From here, we think ... positive seasonal trends and stabilizing bond yields will help equities start to rally again." Manoukian concludes, "Looking out, we think the chances are better than not that the S&P 500 makes a new all-time high by the middle of next year due to decent earnings growth and valuation expansion as inflation fades further."

And Manoukian is hardly alone in his optimism. David Lefkowitz, chief of UBS' U.S. equity investing, penned in mid-October, "While valuations are high relative to history, they are reasonable in the context of low unemployment and falling inflation." Lefkowitz is calling for "a soft-ish landing in the U.S. economy, which should drive a recovery in earnings growth and close to a double-digit total return in U.S. large-cap stocks over the coming year."

Don't overthink it

Will the S&P 500 make a straight-line move to UBS' mid-2024 target of 4,500? Not likely. The index could even lose more ground before starting to make its way to that level, which is 7% higher than its present price. It's also sure to remain volatile between now and then no matter what's in the cards.

If you're still on the sidelines because you fear stocks can't justify their current and forward-looking valuations in the shadow of inflation, fear not. Actual earnings still justify the S&P 500's present price, and most of its stocks' prices too. There's even room for some near-term upside.

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JPMorgan Chase is an advertising partner of The Ascent, a Motley Fool company. James Brumley has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends JPMorgan Chase. The Motley Fool has a disclosure policy.

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