Does the stock market have a valuation problem?

Investing.com -- The S&P 500 ’s valuation has surged significantly in recent years, driven by a rise in forward earnings and fading recession fears.

According to Yardeni Research, the index’s price-to-earnings (P/E) multiple recently hit 22.3, marking a 45.8% surge since its October 2022 low of 15.3, bolstered in part by a 15.5% jump in the forward earnings per share (EPS).

By historical standards, forward P/Es near these levels have been a warning signal.

“If valuations expand much more, we might have to raise our subjective odds of a meltup scenario from the current 25%,” warns Yardeni Research.

One key driver behind this surge is optimism about prolonged economic expansion. Investors are willing to pay a premium for equities as the Federal Reserve’s monetary tightening has softened and the economy has displayed resilience.

The ability of forward earnings to grow before the next recession appears central to these valuations. “The longer the expansion, the longer that earnings have to grow to justify the current multiple,” Yardeni explains.

As recession fears from 2022 gradually eased over the past three years, investors grew more confident in the economy's resilience and earnings growth, driving a sharp rise in valuation multiples despite ongoing monetary tightening.

A significant contributor to this elevated valuation environment is the tech-heavy “Magnificent Seven” stocks, whose collective forward P/E is 29.1, far exceeding the S&P 500 average. Excluding these giants, the forward P/E for the remaining 493 companies in the index drops to 19.5.

Meanwhile, valuation models paint a nuanced picture, Yardeni notes. The Buffett Ratio, which compares the market value of US equities to GDP, reached a record 2.96 in Q2 2024. Warren Buffett has historically flagged levels above 2.0 as indicative of overvaluation.

However, some valuation metrics are less alarming. For instance, the Fed’s Stock Valuation Model, which compares the forward earnings yield to the 10-year Treasury yield , shows near-parity, a departure from the sharp divergences seen in past bubbles.

Lastly, the spread between the S&P 500 earnings yield and CPI inflation, another valuation gauge, is usually negative during recessions and bear markets but has remained slightly positive over the last six quarters.

Yardeni Research suggests that with monetary tightening no longer posing a significant threat to economic growth, other risks could emerge, such as a geopolitical crisis leading to a spike in oil prices, though recent crises have not impacted oil significantly.

Another potential concern is a renewed tariff war under President Donald Trump, who has signaled a readiness to impose tariffs on US trading partners.

“So far, stock investors aren’t fazed by Tariff Man, whom they believe is speaking loudly and carrying a big stick as a negotiating tactic. We agree,” the firm concluded.

Source: Investing.com