There are a number of incongruent factors operating on the market simultaneously creating uncertainty as to whether stocks are overpriced or undervalued. Because the market has never operated before under the specter of a trade war and its unknown economic repercussions, the current investment climate is, in many ways, an economic and financial case of first impression.
On the one hand, there is the reality of a trade war with China and President Trump’s imposition of tariffs on selected goods with other countries. The effects of these policies are uncertain and not enough time has elapsed since their implementation to discern the economic impact.
On the other hand, the economy continues to exhibit signs of continued growth, consumer spending remains relatively high and corporate profits continue to grow. Despite adverse international developments related to trade policies, the market remains stable and close to its January all-time high. The S&P 500 has continued its unbroken rise, advancing 6.7% this year.
In terms of price-earnings ratios, once could argue compellingly that today’s S&P 500 is a bargain. Over the previous 12 months that index has traded at 18.8; this is lower than the market’s February decline, when the S&P 500 traded at 19 times earnings. At the beginning of the year at its peak, the S&P 500 traded at 22 times earnings. By this measure, its current level seems cheap.
Against these measures, the question that needs to be addressed is, has the continued and largely unabated rise of the market made stocks cheaper or more expensive?
Whether one believes the market is overpriced or valuations are low depends, to some extent, on the particular perspective from the questions being raised. The current market environment is rather unique from an historical perspective. After a 10-year bull market surge, the market continues to set new records. The economy remains strong, unemployment historically low and after a decade of zero interest, rates have not increased substantially.
Some interpret the S&P 500 trading close to its all-time high as a positive sign. In light of the reality of Chinese/U.S. trade tensions and imposition of tariffs, the market has demonstrated remarkable resilience. By this measure, despite the continued and unbroken rise of the S&P 500, stocks are relatively cheap.
Stock prices also appear cut-rate in view of robust earnings growth. Large corporations have consistently registered double digit gains for the last three quarters from the same period last year.
According to FactSet, for the latest quarter, many corporations will be registering a 25% increase from the previous year. This represents one of the fastest earnings growth periods since 2010. Thus, from the perspective of stellar corporate profits, stocks appear less pricey on a relative basis than they have at the beginning of the year.
However, it is instructive to note that even though the S&P 500 recently just missed its record high of January and despite another round of spectacular, double-digit corporate profits, that index barely budged over the past three weeks, clawing up less than 1.5%
Investors should also be wary of confusing price-earnings multiples with valuations — particularly since the market’s rise has been disproportionately attributable to a handful of stocks. The valuation question must consider the exaggerated effect the large gains of the tech stocks have had on the entire market as a whole.
Consider the following: Amazon (AMZN, Financial), Netflix (NFLX, Financial) and Microsoft (MSFT, Financial), alone, accounted for 71% percent of the gain in the S&P through early July. Add in Apple (AAPL, Financial), Google (GOOL) and Facebook (FB), and that figure jumps to 98%.
This reverse pyramid market reality, demonstrates tellingly, that valuations are skewed inordinately by the tech titans.
The surge in the share prices of technology companies that has fueled the market's rise for the past several years continues to command substantial multiples, e.g., Amazon’s astronomical current price-earnings ratio of 150. Currently, the tech stocks in the S&P 500 are trading at 21 times their past 12-month earnings — considerably higher than the broader indexes and most other sectors. These historically high valuations have not gone unnoticed, and many investors are beginning to exercise caution.
That is one reason that explains the relative improvement in performance of the consumer staples and other defensive sectors. Many managers are urging clients to pare back their holdings in the currently overpriced tech sector and reallocate into other groups such as staples or financial companies.
The catalyst for the shift in outlook was Facebook’s unanticipated diminished earnings expectations, news that stunned many analysts, ending their predilection for the FAANG group, regardless of price.
For the immediate future, astute investors will need to be cognizant of the ramifications a substantial correction in the tech sector would have for valuations.
I have no position in any of the securities referenced in this article.
