Despite trading well below the highs reached in 2021, the S&P 500 is still relatively expensively valued compared to its own history and other international markets. Valuation can be a reasonable predictor of medium-term stock market performance over a period of years, and so this does not bode well for U.S. equities, even if returns are likely to be unpredictable over the shorter term.
Valuation
Today the S&P 500 trades at 24x current earnings and 29x a Shiller PE which smooths earnings over a 10-year period. Both values are high. Historically the average S&P 500 PE has been in the range of 14x-17x depending on the calculation method.
Of course, that’s just the average and valuations have spent a lot of time below that level. Returning to average valuation levels would imply a stock market decline of around 30% to 50%, though such adjustments can take years to play out, should they occur, and earnings growth can go some way to offset declines in valuation levels.
Changes In Fixed Income
It was argued that higher valuation levels were justified due to a combination of lower interest rates and low inflation. If you are paying a higher valuation for bond investments, due to a lower yield, then maybe stocks should have a more elevated valuation too, as substitute assets.
However, that argument may not be less compelling, because bond yields have risen sharply. The 10-year Treasury yield has risen from under 1% to over 3% in recent years. That an abrupt change and means higher yields on government debt than most of the 1930s-1960s and during most of the 2010s. During all those periods stock valuations were generally lower than today.
Of course, inflation is elevated as well, which is potentially another negative for stock valuations. Still, if U.S. valuations were supports by low bond yields in prior years, that’s arguably no longer the case given the recent Fed moves, with perhaps more to come.
Growth Of Tech
Part of the reason for the elevated value of the S&P 500 is the growth of tech stocks. The S&P 500’s largest company, Apple is now worth more than the all the small cap companies in the Russell 2000 index. Technology now makes up over a quarter of the S&P 500, with Apple
AAPL
and Microsoft
MSFT
the two largest companies making up 14% of the index and trading at premium valuations to the broader index of 30x and 35x respectively on recent trailing 12-month earnings. Though larger stocks such as those included in the S&P 500 may appear richly valued, smaller companies may trade at more of a discount today as the relationship between Apple’s valuation and the Russell 2000 index implies.
Looking Overseas
International markets seem more attractively valued. Asset allocation data from Research Affiliates suggests that though the U.S. along with India and the Netherlands may be trading at rich valuations compared to their own history. In contrast, other markets may be much less expensive in absolute and historical terms.
For example, many emerging market countries including Brazil, China, Poland, South Korea, Turkey and Malaysia appear less expensive in absolute and relative terms on current valuation metrics. Of course, these countries may see greater economic and geopolitical risks than the U.S. economy does, but that’s been true historically and many of these markets may be more attractively valued today than at other times during their history, especially relative to larger U.S. stocks.
Europe, Australia and Japan as well, though not necessarily inexpensive also appear much closer to historically average valuations than the U.S. today.
U.S. large cap stocks, especially in tech, have been expensive for some time now. Since 2021 valuations have come down slightly, but still not to levels comparable with the long-term history of the U.S. market. That may be one reason to consider international diversification for your portfolio, though valuation as a predictor of stock market performance is at best a medium-term indicator of returns.
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