are stocks expensive or cheap?
The Dow Jones Industrial Average, The S&P 500, and the NASDAQ are all at historical highs in January, and many investors wonder if we’ve come too far, too fast, at a time when unemployment remains high, and many parts of the economy are still shut down or not operating at full capacity because of the global pandemic.
At Crystal Waters Capital, we will never pretend to know where the market is going in the short-term; there are simply too many small unknown variables that can affect tomorrow and next week’s ups and downs. However, the big economic drivers always shape the market’s longer-term direction (6-12 months), and despite the all-time highs, the market is still healthy and has room to grow. The market won’t go up in a straight line up but understanding the relative valuation of the market and current trends will give investors’ confidence to reap the benefits of staying invested.
So, let’s dig in…
For the big picture, there are two key factors affecting valuations that investors should understand:
Interest rates and monetary policy have a significant impact on stock prices
Expectations for future years are much more important than the present
Monetary Policy is Creating Excess Disposable Income
This bull market's primary driver has been the policy response to the pandemic, both monetary and fiscal. New research from the Society for Human Resource Management (SHRM) and Oxford Economics shows that the U.S. workforce has lost $1.3 trillion in annualized income due to the coronavirus pandemic. Job losses aren't the only cause of lost income. Pay cuts are responsible for 20 percent ($260 billion) of the $1.3 trillion. This amounts to a reduction in earnings of roughly $8,900 per worker on average (excluding the self-employed). In response, the government has sent out close to $1 trillion in direct payments to consumers to bridge the gap. This is before Congress considers President Joe Biden's additional $1.9T in relief. For those who need the money to make ends meet, the stimulus is merely trying to smooth out the economic hole left by the pandemic. For others, the money is a direct increase in disposable income. When disposable income goes up, so does demand. In the current pandemic, the retail market is also being spurred on by the need to make homes a living, working, education and recreation space. To work from home or anywhere besides the office, people needed laptops, printers, networking, workout equipment and more of the clothing they wore on weekends versus the type of clothing they wore to work. This is why retail sales are at all-time highs, even though we are technically still in a recession, as measured by pure economic output. The other impact from a market standpoint is that excess savings are now going into investments, creating upward pressure on stock prices. As measured by U.S. M2 (all money including savings deposits, money market securities, mutual funds), the money supply increased 26% year-over-year in 2020. This is a staggering amount, and with more still to come, it will continue to drive stock prices higher as long as interest rates stay low.
Interest Rates Allow for Higher Valuations
People using relief money to buy shares of stock makes sense because they may not need the cash right away for necessities, and they stand a good chance of increasing the amount of extra money they have. However, when valuations are taken too high, bubbles can occur in the broad market or pockets of the market, and the possibility of a crash that creates panic selling can emerge. Investors should always be aware that in the short term, the pendulum that is stock valuations will still swing too far in both directions. So, with indexes at all-time highs now, has the pendulum swung too far? Is the market overvalued and due for a correction?
The S&P 500 is a good measure of the broad market, and the price to earnings ratio (the price of the market compared to the total earnings all the companies in the index produce) is one way to look at valuations. The price-to-earnings ratio for the S&P 500 is currently 38. Compared to historical averages, this is rich but should be taken in the context of a very low-interest rate world. Lower rates make borrowing money cheaper and encourage consumer and business spending as well as long-term investments. Lower rates on bonds mean investors tend to favor stocks as yields on bonds decline. Currently, the dividend yield on stocks remains higher than the ten-year Treasury yield, so investors looking for predictable income are moving money from bonds to stocks to maintain or improve their income level. In general, given all this, lower interest rates almost always boost equity prices, and as the money supply increases, the value of the dollar declines, which reduces purchasing power.
The rate of the U.S. 10-Year Treasury is currently at 1.10% - the lowest since 1950. As such, the S&P 500 trading at 38 times earnings is not outside normal bounds. There are certainly pockets of speculative bubbles, but the current bullishness is justified for the overall market.
The Federal Reserve indicated throughout 2020 that it would keep interest rates near zero until 2023 to help the economy fully recover. As Janet Yellen takes over as Secretary of the Treasury, she has already made a case for additional stimulus.
S&P 500 Valuations Without the Top 6 Remain Reasonable
Due to the sheer size and elevated valuations of their stock prices, the Top 6 stocks significantly impact the broad market valuation. If we eliminate those companies, we get a different valuation picture. Interest rates aside, market valuation appears more reasonable when you look beyond the top six U.S. stocks (Facebook, Apple, Amazon, Microsoft, Google, and Tesla) in the S&P 500. These stocks represent over 20% of the total U.S. market and collectively trade at over 40x trailing earnings. Investors have gravitated to these stocks during the pandemic, not only because of their increased use but also because of their financial viability that became attractive during uncertain times. Without these stocks, the broader market of 494 stocks is significantly less expensive, trading at approximately 28 times trailing earnings, or a 26% discount to the full S&P.
Earnings Outlook Remain Positive
There are pockets of the current market that appear a bit frothy. Yet, several sectors of the economy, especially cyclical stocks, present attractive growth opportunities that should last several years. The S&P 500 combined earnings per share (EPS) estimates can tell us where the overall market is headed, and it is clear there is growth ahead.
S&P 500 EPS for 2020 will likely come in at $138-$140/share. Consensus estimates for 2021 EPS are $170 and $200 for 2022. For 2021, this indicates 20%+ earnings growth. This may sound optimistic, but when you consider it is still only 4.3% above pre-pandemic levels in 2019, and the economy has the benefit of sustained low-interest rates and additional fiscal stimulus coming, it appears very attainable and even overly conservative. Suppose we apply a conservative long-term Price/Earnings multiple for the S&P 500 of around 26 (far lower than what is normal for this kind of interest rate environment) to these earnings projections. In that case, we are looking at $4,420 for the S&P 500 and $5,200 in 2021 and 2022, respectively. While markets appear elevated and possibly over-valued at first glance, it’s still a good place for investors.
Stay the course
While the current market valuation appears high, low-interest rates, low inflation, and economic growth support the direction and much of the broader market’s continued growth in 2021 and 2022. Stock markets never increase in a straight line; as such, we will indeed have corrections, both broad and in specific sectors, but the trend remains up, and investors who remain patient and invested for the long term will benefit disproportionately.