While we wait on some big tech earnings (MSFT, META, TSLA, and AAPL all report this week) I thought it would be a good idea to continue with our review of the stock market's macro environment. So today, we'll attempt to tackle the issue of valuations.

To be sure, this is a tricky subject as the question of whether stocks are overvalued or undervalued usually resides in the eyes of the beholder. For example, one investor's overvalued view may be another's sign of positive momentum and strong growth. And so on.

There are many ways to assess the valuation of the market. The Grandaddy of valuation indicators has to be the Price-to-Earnings Ratio (PE). The concept here is simple. Take price and divide it by the earnings. This gives you the "multiple" that investors are willing to pay for the issue in question.

As you might suspect, there are many, many variations on the theme here. You can look at "trailing" (price relative to the last year's earnings) and/or "forward" PE's (price relative to the future earnings). Or the "median" (half above, half below) PE of the market. Or GAAP (generally accepted accounting principles) PE. Or... Well, you get the idea.

Of course, there are many others. Price-to-Sales. Price-to-Book Value. Price-To-Dividend. Etc.

Over the years, I've learned there are a couple of really important things to understand about the subject of valuations. The first, and perhaps the most important, is that the "multiple" investors are willing to pay for stocks changes over time. For example, when things are looking bright - as in the outlook for the economy and earnings - a higher multiple is generally applied. Whereas if the economy is slowing, inflation is high, or there is some form of external event threatening the future, investors become less confident and the multiple is usually at the lower end of the range.

Make No Mistake...

Oftentimes, there is an "argument" in the market about the state of market valuations. However, this is definitely NOT the case at the present time. In short, it doesn't matter which metric you use or which direction you look (backwards or forwards). The bottom line is valuations are high. As in, VERY high.

I have a list of about a dozen valuation indicators that I review on a monthly basis. One of the important takeaways on this blustery Monday morning is that ALL the valuation indicators are singing the same song right now. And the refrain is that the S&P 500's valuations are at levels only seen a few times before in history.

For example, below is a chart of the S&P's PE using GAAP earnings going back to 1990. I like this approach because you can't "mess around" with GAAP accounting. The rules are the rules.

View Larger Chart
Copyright Ned Davis Research Group, All Rights Reserved

As you can see, at 28 times GAAP earnings, the PE is clearly NOT cheap. In fact, as the chart details, the GAAP PE has only been higher right before/after the Dot-Com bubble burst, around the Great Financial Crisis, and around COVID. And as the bears are usually quick to point out, the ensuing market returns haven't been so great.

The next point I'd like to make is that levels of undervalued and overvalued have definitely changed over time. The chart below expands the time horizon for the GAAP PE back to 1926.

View Larger Chart
Copyright Ned Davis Research Group, All Rights Reserved

I've drawn boxes around what I believe are the two different historic valuation regimes. As you can see, from 1926 until around 1990, the valuation levels stayed within a very defined range. Stocks were "cheap" when the GAAP PE got down below double digits and "expensive" above 20.

But then things changed. As mutual funds became the public's primary investing tools and worker pensions gave way to 401K plans, that "range" of valuations shifted. Since 1990(ish) it looks like the market has been "cheap" below 17-18 and "expensive" is now above 30 - according to my take, of course.

Why So High Now?

With valuations currently on the high end of the range, a logical question is, why?

I believe the answer has to do with a couple things. First, there is more money than ever flowing into stocks. Again, pension plans have gone the way of the Dodo bird (a large, flightless bird that became one of the most famous symbols of human-caused extinction) and have been replaced with 401K plans. And my contention is the stock market is a logical place for the vast majority of contributions to go.

Thus, multiples have expanded due to "too many dollars chasing too few goods" - in this case, stocks.

My thinking on the second explanation for why valuations are and have remained high for some time now is related to growth expectations. The key here the economy and, in turn, earnings have continued to grow in a robust fashion. As we discussed in our review of earnings and the economy, earnings are currently expected to grow strongly in 2026 (the current consensus expectation growth rate for S&P 500 EPS is pushing 18%).

Everybody knows the economy is in good shape. Everybody knows earnings are strong. And with inflation behaving fairly well, history suggests this to be a positive setup for stocks. So, everybody has continued to buy stocks.

However, with all that money continually moving into the market, prices have effectively "pulled forward" the future expectations. Put another way, stocks have gotten ahead of themselves in terms of earnings expectations. As such, valuations have become high.

Valuations Don't Matter - Until They Do

It is said that "valuations don't matter until they do - and then they matter a lot." The idea here is that when things are going well, valuations aren't really a concern. As long as the economy continues moving forward nicely and the anticipated earnings show up, growth can wind up taking care of valuations over time.

However, should something come out of the woodwork to upset the apple cart/economy, high valuations can become a problem. Sometimes, a big problem.

An Indication of Risk Levels

I liken the current valuation situation to a homeowner up on a ladder doing some painting. If you are on the second or third rung of the ladder, the risk of falling is relatively low. Sure, you might spill some paint if you lose your balance and fall off. But the potential for injury is limited. In terms of the stock market, when valuations are low, it means that any corrections that result from something coming out of the woodwork are likely to wind up in the run-of-the-mill category.

But, if you are up on the top rungs of the ladder and are reaching to get paint on that last spot (e.g. high valuations), a fall is going to hurt - probably a lot!

The Bottom Line

The key here is that with valuations high, risk in the market is NOT low! Just the opposite, risk is elevated. We are basically high up on the ladder. As long as we don't lose our balance (I.E. the earnings come through as expected) everything will be fine.

But... If a big gust of wind kicks up or we tip the ladder, the resulting fall could get nasty. The point is that any corrections that occur when we are in the high-risk zone could very easily be more severe than normal.

But for now, the outlook looks good and our balance is steady up on that ladder.

Thought for the Day:

Happiness is not something you postpone for the future; it is something you design for the present.

Wishing you green screens and all the best for a great day,

David D. Moenning
Founder, Chief Investment Officer
Heritage Capital Research, a Registered Investment Advisor

Disclosures

At the time of publication, Mr. Moenning held long positions in the following securities mentioned: MSFT, META, TSLA, AAPL - Note that positions may change at any time.

NOT INDIVIDUAL INVESTMENT ADVICE. IMPORTANT FURTHER DISCLOSURES