Is the S&P 500 Overvalued?

Executive Summary

The S&P 500 appears expensive when compared with the fundamentals of the companies in the index. Two common valuation measures—the trailing twelve-month price-to-earnings ratio (P/E) and the Shiller P/E—are both well above their long-term median (73% and 150% respectively – see first & second graph). Although corporate earnings, especially among artificial intelligence companies, have grown quickly, stock prices have risen as well. Thus, the valuation gap remains large. Historically, unusually high valuations have typically been followed by sharp market declines, but these measures cannot predict when a correction will happen. The main takeaway is not that investors should expect an immediate crash, but that gains today are at the expense of gains over the next decade. Investors should understand the risks of today’s high prices and avoid relying too heavily on optimistic forecasts of future earnings.

For further analysis, continue to read The Details below for more information.

“At the root of all financial bubbles is a good idea carried to excess.”
–Seth Klarman

The Details

A frequent topic of my newsletters is how overpriced the stock market is relative to fundamentals, specifically net earnings. In this missive I will examine two fundamental measures of valuation to provide specific data to justify the overpriced claim. Both methodologies involve comparing the price of the S&P 500 with net earnings. Wall Street likes to use “forward” earnings because these earnings can easily be inflated, thus lowering the P/E ratio. By doing so, they are able to state that the market is not as overvalued as some say. I, on the other hand, like to deal with actual historical numbers. The two valuation methodologies I will examine today are the trailing twelve-month price-to-earnings ratio (P/E), and the Shiller P/E. The difference is the Shiller P/E smooths out the business cycle by using 10-year average inflation-adjusted earnings for the “E” in the equation.

When markets become overpriced relative to their earnings, there are two ways to bring valuations down: 1) stock prices must drop, or 2) earnings must rise without a corresponding rise in stock prices. In a typical market cycle, earnings rise causing investors to get excited and bid up prices. This continues until prices become too high relative to actual earnings. Over time, fear-of-missing-out on the rise in stock prices pulls many of the remaining investors into the market, sending prices ridiculously high compared to corporate earnings. A bubble ensues and eventually pops, sending the stock market plunging.

Today, the market is being led by AI (Artificial Intelligence) related companies. These companies have displayed phenomenal earnings growth. The real question, as analyzed in previous newsletters, is whether the growth is sustainable. Some analysts are hanging their hats on earnings growth being able to close the overvaluation gap. The problem is that as earnings have grown, so have stock prices. The level of overvaluation remains high because as the “E” grows, so does the “P” in the P/E ratio. And the growth is largely attributable to one sector which has not proven the ability to produce sustainable results.

Let’s examine the S&P 500 trailing twelve-month P/E ratio in the graph below from multpl.com. The current P/E based upon the last 12-month’s net earnings is 26.01. At the start of the year, it was 27.98. The ratio has dropped about 7% due to a jump in earnings of roughly 20%. However, the long-term median P/E is 15.08. That means today’s P/E is 73% above the median. It would take a drop in the S&P 500 of 42% to bring the price back to its long-term median level. That drop would only bring the price to the median. Typically, when a bubble pops, the market drops to prices below the median, which would require a larger drop.

Because the Shiller P/E smooths out the business cycle using long-term inflation-adjusted earnings, it is typically a better indicator of what average growth in the S&P 500 is likely to be over the coming 10 years. The graph below (via multpl.com) shows the Shiller P/E is currently 40.36. This level has only been exceeded slightly during the peak of the Technology Bubble in 2000. The current level is far above what was experienced prior to the Great Depression.

The long-term median valuation level for the S&P 500 using the Shiller P/E is about 16.13. The current reading is a whopping 150% above the long-term median. A drop in the S&P 500 of 60% would be required to bring its price down to the long-term norm. And of course, any drop below the median, resulting in an undervalued market, would require a drop of over 60%. These are not far-fetched numbers. A study of the aftermath of all of the prior great stock market bubbles reveals similar results. In fact, after the October 1929 crash, the Dow proceeded to drop around 89%! The Nasdaq 100 technology index fell about 83% after the Tech Bubble popped from 2000-2002.

These valuation methods are not timing indicators. They do not suggest a correction is imminent. What they do tell us is that the market will likely be net flat over the next decade, with a lot of volatility in the middle. Sustainable earnings growth can help lower valuation levels only if prices don’t jump in conjunction with the earnings increase.

The Tech Bubble was a great example of how using “forward” earnings in one’s valuation methodology is fright with risk. Using actual fundamental results, the stock market remains massively overvalued.

The S&P 500 Index closed at 7,624, down 0.5% for the week. The yield on the 10-year Treasury Note fell to 4.99%. Oil prices increased to $103 per barrel, and the national average price of gasoline according to AAA fell to $4.29 per gallon.