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Valuations aren't overstretched after record year for stocks, strategist says

The S&P 500’s (^GSPC) near 30% return last year was driven in large part by multiple expansions, which sent valuations well above their historical averages.

Typically, a run-up in stock prices in absence of earnings growth leaves investors on edge, leading to questions over whether assets are overvalued and due for a correction.

But as Jeff Schulze, ClearBridge investment strategist, explained to Yahoo Finance, current valuations may not be as stretched as they seem on the surface.

“You look at the last 11 economic cycles and at the market multiple that you saw at the peak of those cycles, you compare that market multiple to the five-year average leading up to that peak, (and) on average you’ve seen a market multiple premium versus that five-year average of around 25%,” Schulze said. “Today we only trade at a slight premium of 6%. So that would suggest that multiples could expand further from here.”

Schulze’s assessment was roughly in-line with the market multiple premium other firms have assigned to the S&P 500.

The forward 12-month price-to-earnings (PE) ratio for the S&P 500 was 18.4 as of January, according to FactSet, coming in well above its 10-year average of 14.9. But that premium narrows considerably when compared to an estimated 5-year average PE ratio of 16.7 for the S&P 500, based on FactSet data.

Further multiple expansions will come as investors get off the sidelines and pile back into equities, Schulze said. Optimism around the near- to long-term outlook is poised to help lure investors back to stocks, as a phase one deal gets signed between the U.S. and China and clarity around other geopolitical events like Brexit materializes, he added.

A trader looks up at a chart on his computer screen while working on the floor of the New York Stock Exchange REUTERS/Lucas Jackson

“Even though we had a great year in the market last year, investors really haven’t participated in it,” Schulze said. “If you look at investor flows, you’ve seen a huge inflow into bond and money market funds of around $870 billion. You’ve seen net outflows of global equity funds of $215 billion. The net difference between the two is $1.1 trillion which is the largest in financial market history.”

In absence of a downturn, “there’s going to be a little bit of FOMO” – or a fear of missing out on further returns – “and investors will chase back into the equity markets and you could see multiple expansion from here,” he said.

“But also if just markets continue to melt higher, people will feel better about the economy, about markets generally speaking – and you have $3.6 trillion in money markets right now,” he said. “That’s second to an all-time high we had earlier this cycle.”

And as Schulze said, that leaves a lot of dry powder waiting to be put to work.

Emily McCormick is a reporter for Yahoo Finance. Follow her on Twitter: @emily_mcck

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