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The counterintuitive truth about stock market valuations: Morning Brief

Sam Ro
·Managing Editor
·4 min read

Monday, November 23, 2020

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Market valuations aren't mean reverting

Stock market valuations can make investors nervous when elevated above long-term averages.

And valuations are very much elevated right now.

Read more: How to think about stock valuation: The full breakdown

“The forward 12-month [price/earnings] ratio for the S&P 500 is 21.7,” Factset’s John Butters observed on Friday. “This P/E ratio is above the 5-year average (17.4) and above the 10-year average (15.6).”

As we’ve written quite a bit, rich valuations alone are no reason to avoid or dump stocks. And they’ve historically revealed almost nothing about what stocks do in the next 12 months.

And as Myles Udland noted last week, valuations often spend extended periods of time far above average while spending very little time trading near their averages. (See more here, here and here.) Indeed, much of the gains you see in the stock market have been achieved while valuations appeared expensive.

Stocks traded above average valuation levels for much of the last bull market. (Factset)
Stocks traded above average valuation levels for much of the last bull market. (Factset)

It might be unsettling, but the counterintuitive truth is valuations don’t arbitrarily gravitate back to historical averages.

“The long cycles we see in the P/E ratio are driven by economic factors,” Wells Fargo analysts said in a 2016 note. “The S&P 500 P/E ratio is not stationary and not mean reverting...”

In recent years, everyone from billionaire investor Warren Buffett to Fed Chair Jerome Powell have stressed the importance of rates when considering valuations. And with rates having been at unusually low levels for years by historical standards, you could argue we’ve been in a new market regime that justifies elevated P/E ratios.

Valuation considerations for 2021

It’s with all this context that we read Wall Street’s 2021 stock market forecasts, which include a lot of strategists making the case for higher prices even as valuations remain elevated.

"Yes, valuations appear stretched at first glance, but they also need to be considered within the context of historically low interest rates and little inflation, ingredients that are likely to persist throughout 2021 and beyond, in our view,” BMO Capital’s Brian Belski wrote on Thursday. “When viewed through this lens, we believe it is not unreasonable for market valuation to sustain (or even expand slightly) from its current level."

Belski sees the S&P 500 climbing to 4,200 next year.

On the other hand, Morgan Stanley’s Mike Wilson is a bit more cautious, forecasting the S&P to top out at 3,900.

"With respect to multiples, we expect rates moving higher will be a headwind to valuations, though falling equity risk premium in a recovering economy will provide some offset,” Wilson said. "The market has entered the phase of the economic recovery when multiples compress as earnings move higher.”

Wilson’s point about multiples shrinking as earnings rise is worth reiterating because it’s a reminder that prices do not have to fall for valuations to contract. It’s simple math.

That same math helps to explain why Credit Suisse’s Jonathan Golub sees the S&P climbing to 4,050 as valuations come down: "Our target suggests multiples will contract from 21.9x today to 21.3x by year-end 2021, as earnings grow into currently elevated multiples."

We’ll see what stock prices do in 2021. But don’t be surprised prices continue to rise despite what appear to be “stretched” valuations.

By Sam Ro, managing editor. Follow him at @SamRo

What to watch today

Economy

  • 8:30 a.m. ET: Chicago Fed National Activity Index, October (0.27 expected; 0.27 in September)

  • 9:45 a.m. ET: Markit US Manufacturing PMI, November preliminary (53.0 expected, 53.4 in October)

  • 9:45 a.m. ET: Markit US Services PMI, November preliminary (55.0 expected, 56.9 in October)

  • 9:45 a.m. ET: Markit US Composite PMI, November preliminary (56.3 in October)

Earnings

Pre-market

  • 7:30 a.m. ET: Warner Music Group (WMG) is expected to report adjusted earnings of 5 cents per share on revenue of $1.11 billion

Post-market

  • 4:05 p.m. ET: Urban Outfitters (URBN) is expected to report adjusted earnings of 44 cents per share on revenue of $929.28 million

  • 4:05 p.m. ET: Agilent Technologies (A) is expected to report adjusted earnings of 92 cents per share on revenue of $1.4 billion

  • 4:05 p.m. ET: Nutanix (NTNX) is expected to report an adjusted loss of 58 cents per share on revenue of $297.27 million

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