Stocks are expensive, again. A strong bounce does that. But right now, sustainable market gains may be hard to come by for a while because of something else that’s high: earnings multiples.
First, the big picture: The
is up 10% since March 8, when it fell to its lowest closing level of the year and entered correction territory.
And the rally comes despite the fallout from the Russia-Ukraine war: a US ban on Russian oil that has reduced supplies and pushed up prices. The extra cost is hitting Americans at the pump, adding to the white-hot inflation triggered by households flush with cash and businesses struggling to meet demand with enough supply.
Even before the war, the Federal Reserve decided to reduce its bond holdings and expects increase interest rates 10 times more within the next two years to reduce inflation, a move that is also likely to slow economic growth.
However, against this backdrop, stocks have gained and their earnings multiples have risen. An earnings multiple is the price of a stock divided by its expected earnings per share. An example: a $100 share has a multiple of 20 if next year’s EPS is expected to be $5. The S&P 500’s aggregate multiple of expected earnings per share for next year is about 20 times, up from this year’s low of 18 times.
A multiple of 20 times is high for a couple of key reasons. First of all, February was the last time the aggregate multiple was 20 times, and the S&P 500 was still down. But since then, bond yields have risen, partly in response to inflation. Higher rates on long-term bonds make future earnings less valuable, which often means a lower earnings multiple on a stock.
Another way to gauge whether multiples are too high is to compare stock valuations to bond yields, using a metric called the equity risk premium.
At 20 times earnings, every dollar of earnings from the S&P 500 earns the investor 5%. The 10-year Treasury yield is at 2.32%. The annual return on the stock market is about 2.7 percentage points higher than the annual return on the government bond.
The higher return on stocks can be explained simply: Investors demand a higher return in exchange for taking on the additional risk. Still, just to be clear, that 2.7% risk premium is a historically low excess return, about where it tends to bottom out since the end of the financial crisis, according to data from the investment bank.
In times of economic uncertainty, investors often demand an additional return of more than 4% on stocks versus bonds, an outperformance that would force stock prices down from here.
“It makes little sense that the equity risk premium is at post-Great Financial Crisis lows given the heightened risk to earnings growth,” wrote Mike Wilson, head of US equity strategy at Morgan. Stanley.
To be sure, though, none of this means that the stock market is necessarily in for another correction, just that big gains in the short term are probably overblown.
“At a multiple of 20, I don’t think the risk reward is that compelling” for the S&P 500, said Keith Lerner, co-chief investment officer at
a commercial bank
Others agree with Lerner.
“Today we say that chasing the top market is hard,” wrote Dennis DeBusschere, founder of 22V Research, an investment research firm.
right on the nail, the S&P 500 wobbles at this high valuation level. Earlier in the week, the index closed just above 4600, or about 20 times the gains. It has since fallen and is now just below 4,600, the same level as two big sell-offs in February.
High anxiety about economic growth explains the drop. Analysts could potentially lower earnings estimates if the economy falters enough.
So high stock prices, high earnings multiples, equity risk premium, economic uncertainty – is there anything that investors can make feel good?
There are. Investors are not likely to pay a higher price premium to own shares than they are paying now.
Email Jacob Sonenshine at firstname.lastname@example.org