U.S. Market Valuations Are Not Expensive, Even After The Rally Back Towards Historical Highs

Summary

• The US market is currently trading at an aggregate trailing P/E of 23.2x.
• This is near the high-end of historical valuations in markets with similar inflation and tax environments.
• However, when embedding expectations for future growth, forward P/E valuations are more manageable, or even cheap, at 17.5x, suggesting continued market upside is warranted.

Over the past 100 years, the median P/E of the S&P 500 has been 16.2x, and the S&P 500 is currently trading at a 23.2x multiple, suggesting an expensive market.

However, comparing valuations to a 100-year median P/E doesn't tell us the whole story. Context is essential. There are many important drivers of context over time, two of which being tax rates and inflation. Historical analysis and economic theory both show that lower investor taxes lead to higher valuations, and higher inflation leads to lower valuations (and vice versa). As such, when thinking about the context of current market prices, we should consider the environment in which we are investing.

A simple breakdown of high and low tax environments, coupled with a breakout of different inflationary situations, results in divergent P/Es, meaning very different valuation environments:

Or shown differently:

The U.S. is currently in a low (but rising) inflation environment, coupled with low dividends and capital gains tax rates, relative to historical rates that are likely to persist. Given the current makeup of the US legislative branch and the Federal Reserve's long-term focus on a 2% inflation target (notwithstanding recent news), we are in an environment that has historically resulted in a median market P/E of 20.1x.

Currently, valuations sit just above this level, with a P/E on the S&P 500 of 23.2x. With this new context, valuations do not appear exceptionally expensive but are still above average based on the market environment.

However, this doesn't account for growth

In two earlier articles, here and here, we talk about the reasons to believe we are entering a period of corporate growth. Specifically, there are reasons to believe corporations will need to ramp up spending and that there is ample liquidity to support this increased spend.

This increase in aggregate spending should support aggregate analyst expectations for increased earnings growth in 2018 and 2019, which Valens' Uniform Accounting analysis supports. This also suggests valuations are not nearly as expensive as they first appear. In fact, if we look out one year for EPS estimates, forward P/Es are just 17.5x for the S&P 500 currently. This is still a 13% discount to the 20.1x average P/E for similar markets historically.

The market appears to have ample more room to run in this bull market.

Our Chief Investment Strategist, Joel Litman, chairs the Valens Research Committee, which is responsible for this article. Professor Litman is regarded globally for his expertise in financial statement analysis, fundamental research, and particularly Uniform Accounting, UAFRS.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.