By Krishna Memani, Chief Investment Officer
On every valuation metric - price-to-earnings, price-to-sales, price-to-book, price-to-cash flow - U.S. stocks are currently trading above their long-term averages. The current U.S. equity cycle is already the second longest on record and valuations are now more extended than they have been in every other cycle besides 1987-2000.
Valuations, however, should not simply be viewed in isolation. First, it is important to note that valuations historically have not been reliable predictors of near- to intermediate-term returns. Valuations also have to be examined within the context of the current macroeconomic, interest rate, inflation, and policy environment.
Current Valuation Levels Don't Suggest A New Bear Market
In the past, there has only been a minimal to modest correlation between U.S. equity valuations and their returns over subsequent periods of 5 years or less. What that means is that simply knowing that equities are trading at elevated valuations provides very little insight into how equity markets will perform in the short and intermediate term.
Investors may want to keep these key considerations in mind:
- Most valuation metrics, even the cyclically adjusted price-to-earnings ratio, paint a far more sanguine picture of the market than the headlines would suggest.
- Stocks, on the basis of their earnings yields, still look attractive relative to bonds, even this late in the cycle.
- While certain segments of the market, like technology, look moderately expensive, these valuation differentials, when viewed in the context of prior periods of excess like the tech bubble of the late 1990s, appear to be far more contained.
- International and emerging stocks are currently trading at discounts to U.S. stocks and are supported by solid and improving fundamentals, which may provide attractive opportunities for investors.
- The U.S. Federal Reserve typically raises rates during periods of low unemployment, sound wage growth, and improving economic activity, all of which may potentially benefit equities.
In our view, solid economic growth, low and modestly rising interest rates, contained inflation, and benign policy all support a continued strong environment for equities.
For more details on our positive outlook for stocks, be sure to view the accompanying paper.
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