Pricey Stocks, Prudent Moves: A Historical Lens on Market Expensiveness

The stock market isn’t just expensive; it’s alarmingly pricey. Nevertheless, historical trends suggest the potential for significant gains from its current level.

In the year-to-date, the S&P 500 has surged nearly 15%, propelled by expectations that the Federal Reserve will refrain from further interest-rate hikes due to a declining inflation rate. Additionally, optimism around artificial intelligence boosting Big Tech stocks has played a role.

Currently, the S&P 500 trades at around 18 times the aggregate earnings per share expected from its component companies over the next 12 months, well above the historical average of about 15 times. Yet, this ratio doesn’t fully capture the true extent of stock expensiveness, especially considering past instances where it has remained above 20 for extended periods.

The valuation of stocks is closely tied to interest rates. With the index trading at 18 times earnings, investors can expect an annual per-share profit of about $5.50 for every $100 invested. This represents just a 1% premium over the 4.5% offered by holding safe 10-year Treasury debt, indicating a historically low equity risk premium.

If the equity risk premium were at its long-term average, the earnings yield on the S&P 500 would be 7.5%, equivalent to the index trading at 13.3 times earnings—a clear sign of the stock market’s alarming expensiveness.

However, historical data suggests that when the equity risk premium is exceptionally low, stocks tend to experience double-digit growth over the following year. Currently, with the premium hovering between zero and 1%, the average expected move for the S&P 500 in the next year is just over a 12% gain, according to RBC.

Contrary to historical patterns, the equity risk premium is not negative, indicating that stocks yielding less than the S&P 500 are not leading to a decline in the index in the following year.

Investors are optimistic about future earnings, confident that they will surpass Wall Street predictions. Factors such as sustained economic growth, defying expectations of a recession, and expectations of double-digit annual EPS growth in Big Tech contribute to this optimism.

If this positive scenario materializes, analysts will likely revise their earnings forecasts upward. This could result in a lower forward price/earnings multiple for the S&P 500, making the market appear less expensive.

Furthermore, as bond yields potentially drop, the earnings yield would rise, further increasing the equity-risk premium. Investors are already contemplating how to position themselves for this potential scenario, exploring which stocks to own if yields have peaked.

The question remains: Can stocks continue to rally? It’s a reasonable expectation given the current dynamics.

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