A groundswell of concern is building on Wall Street that the U.S. stock market is in dangerously high territory. This week, the Nasdaq Composite hit a new high as the Dow Jones Industrial Average and S&P 500 remained in record territory — and they are up 28%, 18% and 16% respectively from a year ago. Meanwhile, the S&P 500 is trading at 25 times trailing 12-month earnings compared with a historical average of 16. The value of the stock market is nearly 150% higher than the nation’s GDP, a level last seen around the dot-com bust in 2000, according to the World Bank. And a BofA Merrill Lynch survey showed that 81% of fund managers think U.S. stocks are overvalued.
The Fed has weighed in as well. In the minutes of its March meeting released earlier this month, it observed that equity prices are “quite high relative to standard valuation measures.” The widely followed Cyclically Adjusted Price-to-earnings Ratio (CAPE) stands at a historically high 29, according to creator Nobel laureate Robert Shiller. Last week, he told CNBC that the U.S. stock market “hasn’t been this overvalued except a couple of times around 1929 (the Great Depression) and around 2000. We’re above the 2007 valuation” right before the financial crisis, although he also said the market could still have room to run.
The euphoria flies in the face of several lackluster economic reports. In the first quarter, the U.S. economy grew the slowest in three years, with U.S. GDP up 0.7% after inflation, according to the initial estimate by the Department of Commerce. Manufacturing fell to a four-month low in April while consumer spending — which drives two-thirds of the economy — remained flat in March. On the positive side, S&P 500 companies are reporting double-digit earnings growth for the first time in six years, according to FactSet. What also seems to be driving the market are hopes that the Trump administration will be able to cut federal corporate income tax rates to 15% from 35% and reduce the number of regulations restricting businesses.
“The most important thing that I think is spurring the markets is the forward guidance [in corporate earnings.] For the first time in years, the forward guidance is even maintained or being raised,” Wharton finance professor Jeremy Siegel said on the Wharton Business Radio’s Behind the Markets show on April 28, which airs on SiriusXM channel 111. In past years, he said, companies typically project overly rosy earnings at the beginning of the year that often see big corrections later.
But “for the last few weeks, I’ve noticed a maintenance of the full year 2017 earnings” that, if realized, correlate to an S&P 500 valuation of 18 times earnings, Siegel said. He believes that level is “quite reasonable” compared to the “scary 21, or 22” or higher multiples. Siegel had correctly predicted the Dow’s rise to 20,000. Further, he believes this “Goldilocks” environment of “low interest rates and great earnings guidance, and the rest of the world beginning to take off … is a perfect environment for stocks.” And his projection does not even take into account any coming cuts in the corporate tax rate. “That will be a bonus,” Siegel said.
“It’s not obvious high P/E levels will lead to market downturns, no less a ‘big crash.’”–Donald Keim
Siegel also pointed to some limitations of Shiller’s CAPE ratio. “When he talks about valuation or P/E (price-to-earnings) ratio, he uses a 10-year lagging average, which includes the Great Recession’s … very low earnings base and uses GAAP earnings, which are very conservative and not what the Street uses,” he told CNBC on April 27. “It says there’s one right price for equities. We are not in that world. We’re in a lower interest rate world.” Adds Wharton finance professor Donald Keim: “It’s not obvious high P/E levels will lead to market downturns, no less a ‘big crash’.”
Priced for Perfection?
Further goosing the markets was the outcome of the first round of the French presidential election last week, which saw far-right candidate Marine Le Pen come in second behind center-rightist Emmanuel Macron. Le Pen is anti-European Union and Eurozone and a French exit does not bode well for the continent especially after Brexit. “We’re seeing the markets expecting that Marine Le Pen will not win next year in France and some optimism that the EU and the euro will not collapse,” observes Wharton accounting professor Matthew Cedergren.
As for valuations, Cedergren says the market’s average P/E of 16 is just that — an average. “A lot of those years, it was above 16 or below 16. There have been many times when the market has been trading above its historical average in terms of valuation and it turns out, ex post, that those valuations were justified, and there were times when they were not justified.” The only way to gauge whether the market has overheated is after the fact. “Markets are an ex ante bet on what’s going to happen.” That said, Cedergren does not think the market is at “internet bubble” levels which saw some tech stocks trading at 600 times earnings.
“I have been surprised that the market hasn’t had much of a correction since the election, and has shrugged off most things that could normally cause a correction.”–David Erickson
Still, the market is not cheap. “I have been surprised that the market hasn’t had much of a correction since the election, and has shrugged off most things that could normally cause a correction,” says Wharton senior fellow David Erickson, who is also a former operating partner at VC firm Bessemer Venture Partners. “As equity markets trade on future expectations, there is a lot of perfection seemingly priced into the current market’s expectations.” Adds Wharton accounting professor Paul Fischer: “Stock market valuations are somewhat frothy relative to historic norms,” but they can be justified by “either relatively optimistic expectations of earnings growth,” low discount rates or both.
“Identifying exactly what has improved along the growth dimension is somewhat unclear at this stage,” Fischer says. “For example, one might argue that corporate tax reform will lower corporate tax rates, which will provide a significant boost to future earnings. Large multinational corporations, however, already have effective tax rates that are substantially lower than current statutory rates because they engage in sophisticated tax avoidance activities. Hence, it is unclear whether a cut in statutory rates arising from tax reform will boost future earnings all that much.”
Nevertheless, the market seems to be reacting to the possibility of coming lower tax rates that could kick up earnings and bring down the P/E ratio, says Wharton finance professor Bulent Gultekin. Further, a catalyst for stocks going forward are the improving economies in Europe and across the world that “could provide a very positive outlook for everyone. Those expectations would help the markets.” However, he warns about the impact on the markets if the Trump administration does not deliver on the promised tax cuts and deregulation.
Indeed, Wall Street’s excitement over Trump’s promises may be overblown. “I’m not sure this optimism is warranted,” says Wharton finance professor Itay Goldstein. “At the end of the day, cutting taxes is not easy, as we are seeing right now” especially in light of large budget deficits. Rolling back regulations also may be tougher to do than expected since they were established for “a good reason,” he said. The rules put in place after the financial crisis aim to make the system “stable and not fragile…. When these realizations come into the financial markets, it seems that prices are going to be in danger of starting to fall.” He adds that the Fed’s years-long practice of using monetary policy to stimulate the economy is on its way to being reversed “so I don’t think that will continue to push [stock market] prices up.”
“The most important thing that I think is spurring the markets is the forward guidance [in corporate earnings.]”–Jeremy Siegel
But one must also look at the market’s valuation within the context of other investment opportunities, according to Jeremy Schwartz, director of research at WisdomTree Asset Management and host of Wharton’s Behind the Markets show, in an interview with Knowledge at Wharton. “The [stock] prices by themselves are high but earnings are reasonable — you’ve got good earnings growth. And then, you’ve got to always judge the opportunities of stocks vs. bonds. That absolutely matters.” People traditionally park their funds in three places: stocks, bonds and cash. And the best return is still in stocks despite the recent run-up in prices, Schwartz notes. “We’re starting to get a positive trade in our cash accounts, but it’s still historically very low,” he adds. For example, bank accounts continue to pay low interest rates.
Meanwhile, the 10-year Treasury note is yielding 2.3% — or about 0.4% after accounting for inflation — compared to 3.5% after-inflation returns historically for long-term bonds. So “bonds are much more expensive compared to their history than stocks are,” Schwartz says. “Stocks are not that expensive, even if you took a 20 P/E ratio on the S&P 500 that gives you a 5% earnings yield compared to 40 basis points (0.4%) in real bond yield. It’s still an attractive return for stocks over bonds.” He notes that a lower corporate tax rate will help stocks even more.
Goldstein concurs. “People are looking for places to invest. It’s hard to put your money in a CD and a savings account because the return is very low. People are looking into other ways to invest their money. Stocks, bonds, real estate — all those prices have been going up as a result.”
Risks to the market include signs that the economy is entering a recession, Schwartz says. Indicators include higher short-term interest rates than long-term rates, resulting in an inverted yield curve. “We don’t have anywhere near that today. You have your 10-year bond at 2.30% and your short-term rates are below 1%, so I don’t think signs are pointing to recession. I think we have a healthy economy,” he says. But the markets want tax reform and the longer it is put off, the greater the risk of a selloff.
“Unless you’re extremely tuned to the market and have very good foresight as to what’s going to happen, it’s very hard to time the market.”–Itay Goldstein
Schwartz says investors concerned about market highs can look for stocks that are trading at lower multiples. WisdomTree uses an earnings-weighted approach to buying stocks by excluding unprofitable companies. “It’s interesting how much of the P/E ratio of the S&P 500 is driven by unprofitable companies,” he says. “We look at our Earnings 500 Index today, the P/E on that is around 16 times earnings, which is very close to the long-term historical market multiple. … That’s very reasonable.” Adds Siegel in an interview with Knowledge at Wharton: Investors can buy market index ‘puts’ to protect against declines, or stocks that pay good dividends to offset price drops.
Another opportunity are tech, consumer and industrial stocks — which Schwartz calls ‘quality’ stocks. He says they typically are more expensive than high-dividend stocks but currently they are not trading at a premium. Emerging markets also offer better values, due to higher political and currency risks. As an example of the allure of emerging markets, Schwartz cites the 2016 Yale Endowment report, which revealed that it allocated 15% of its assets to foreign equities versus 4% for U.S. stocks. In developed economies, he says, Japan offers a reasonable valuation.
At the end of the day, however, most people should not try exit the market when they think it’s high and then jump back in when they believe it’s low. “You might take the money out to avoid the correction, but you don’t know when to put your money back in” and miss out on some gains, Goldstein says. “Unless you’re extremely tuned to the market and have very good foresight as to what’s going to happen, it’s very hard to time the market.”