Daily Spotlight

Lofty Stock Valuations

On our five-year smoothed earnings figure (which is still depressed by the pandemic), stock prices (as expressed by the S&P 500) are well above the high end of our fair value range, which our model pegs at 4,200. Our stock-market valuation model takes into account factors such as stock prices, five-year normalized earnings (three historical years, including the sharp drop during the pandemic, and two forward-looking), GDP, inflation, and T-bond and T-bill yields. We note that stocks rarely trade right at fair value. Since 1960, on average, the index has traded at a relatively tight 2.5% above fair value, but the standard deviation to the mean is 16%. As such, we normally expect the S&P 500 to trade between 14% undervalued and 18% overvalued. At current prices, the stock market is about 50% above fair value, implying that investors may be overly optimistic about equities in the coming months. Though we are still bullish on the economy, earnings, and continued historically low interest rates, we'd feel better about the longer-term outlook for stocks if valuations were not so stretched. Several factors could improve valuations: a pullback in stock prices (seemingly underway and which occurred three times in 2021); lower bond yields; or better earnings, which we expect to see during the current reporting season. ...  at fair value. Since 1960, on average, the index has traded at a relatively tight 2.5% above fair value, but the standard deviation to the mean is 16%. As such, we normally expect the S&P 500 to trade between 14% undervalued and 18% overvalued. At current prices, the stock market is about 50% above fair value, implying that investors may be overly optimistic about equities in the coming months. Though we are still bullish on the economy, earnings, and continued historically low interest rates, we'd feel better about the longer-term outlook for stocks if valuations were not so stretched. Several factors could improve valuations: a pullback in stock prices (seemingly underway and which occurred three times in 2021); lower bond yields; or better earnings, which we expect to see during the current reporting season.   more

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