The S&P 500 index has seen an impressive rise of nearly 50% since its low point 18 months ago, with little evidence to suggest it will decelerate anytime soon. Already this year, the index has climbed 8% and has reached all-time highs 18 times.
Observers are beginning to question whether the market is overheating. Supporters of the continued rise in shares acknowledge that they seem costly, but argue that this may not be a significant issue. Savita Subramanian, from Bank of America, recently referred to the S&P 500 as “shockingly overpriced” in comparison to its past. According to 19 out of 20 valuation measures, stocks appear more expensive than they have historically been. The index’s value is currently 24.5 times its trailing earnings – a higher ratio than 95.5% of its previous records.
However, Subramanian doesn’t interpret this as a red flag. She highlights that profit margins have almost doubled from 6% in the 1980s to nearly 12% nowadays. The S&P 500 is “half as levered, superior in quality, and has less earnings instability than in the previous decades”, thus, she reasons, it justifies a higher price.
In parallel, Michael Batnick from Ritholtz Wealth Management points out that the cyclically-adjusted price-earnings ratio of S&P 500 has averaged at 26 over the recent 20 years. Before the emergence of the dotcom bubble, such a rate was singularly observed during the speculative craze of the 1920s, leading to the 1929 Wall Street catastrophe.
The lesson learnt from history is clear: the stock market norms have shifted. Valuations previously considered inflated “seem to be the new status quo”, argues Batnick.
It’s noteworthy that these high valuations are majorly found in a handful of extremely profitable, mega cap tech enterprises, comments Goldman Sachs. This explains why, despite appearing costly, these prices are fundamentally justified. In essence, the US market may seem expensive, but there is a valid explanation for this apparent high cost.