Stocks’ High Valuations May Be Justified

Stocks’ High Valuations May Be Justified

over 3 years ago2 mins

Mentioned in story

At first glance, global stock markets look worryingly expensive compared to company earnings: only during the dotcom bubble and immediately prior to the 1929 crash have US valuations been any higher. Dig a little deeper, however, and those precipitous share prices – like Justin Timberlake circa 2002 – may in fact be justified 🕺

What does this mean?

As global stocks rebound ever higher from March’s bear market, perhaps supported by the same influences which magnified their downwards dip – an increased focus on volatility and derivatives – investors are getting worried. 78% of professionals responding to a recent Bank of America survey, the highest proportion ever, said they thought markets were overpriced.

A simple stock price versus company earnings (“P/E ratio”) comparison appears to support that view: 80% of world stock markets are currently valued in their upper historical quartile, with US stocks sitting at the 92nd percentile.

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Experts’ earnings expectations may, of course, soon be adjusted upwards to reflect a reopening global economy. But there are also other factors at play when it comes to valuations. As investment manager Fidelity pointed out this week, P/E ratios don’t account for things like interest rates, corresponding “equity risk premiums” – or, crucially, shareholder returns in the form of dividends and stock buybacks… 🤔

Why should I care?

Once you consider today’s record-low interest rates and historically high shareholder distributions, valuations suddenly look somewhat more sensible. When factoring in stocks’ dividends and buybacks, the US S&P 500 is currently valued at just the 65th percentile in its history – not nearly as extreme as it previously seemed.

Interest rates, risk premiums, and payout ratios (pink) suggest markets aren’t so mad
Interest rates, risk premiums, and payout ratios (pink) suggest markets aren’t so mad

Of course, that raises the question of what happens if those lucrative buybacks shrink. Perhaps unsurprisingly, 2020 looks set to be a leaner year than the last couple – and if a regime change in the US leads to higher corporate taxes, 2021 could mean even this alternative valuation model shows up stocks as expensive. At any rate, investors would do well to beware of oversimplifying things – and make up their own minds whether stocks are worth it 😉

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