4 Charts Back up Powell’s Comments About High Stock Valuations

Federal Reserve Chair Jerome Powell caught investors’ attention on Tuesday when he said that the US equity market is “fairly highly valued.”

While it’s never nice to hear the Fed chair speak in less-than-bullish tones, Powell’s observation shouldn’t have come as a surprise to investors. After all, he’s right — at least for the most part.

By many measures, the stock market broadly is historically expensive. Take it from Bank of America, which pointed out this week that 19 out of 20 valuation metrics it tracks show the market is historically expensive, with four of the gauges at all-time highs.

Let’s dive into a few measures that show stocks are pricey.

One of the most cited and followed metrics is the Shiller CAPE ratio, which measures the S&P 500’s current price compared to a rolling 10-year average of earnings. This week, it hit its highest level since the peak of the dot-com bubble.

High stock valuations can be a foreboding signal for long-term returns. The Shiller CAPE ratio in particular has a high correlation with 10-year forward returns. When valuations are elevated, future earnings upside is already priced in, usually resulting in poor subsequent performance for share prices.

The Shiller CAPE ratio isn’t perfect, though. One of its limitations is that, because it measures a 10-year rolling average of earnings, it can be slow to reflect current conditions and therefore may not be as great a predictor of future returns as is believed, said Yale economist William Goetzmann.

“Every observation is just moving forward one year, one month, so basically you’ve got a lot of correlation between one observation and the next one,” Goetzmann told Business Insider earlier this month. “It’s very difficult to be confident about the results of that analysis when you have overlapping returns of 10 years or even five years.”

Tom Essaye, the founder of Sevens Report Research, also pointed out that while the Shiller PE is an impressive metric, it’s not forward-looking.

“When you’re in the market, it doesn’t matter what it’s done in the past, it only matters what it will do in the future,” Essaye told BI. “That’s why people on the street use forward PE exclusively.”

Still, other valuation measures show froth.

Enter the forward PE. The metric, which measures the S&P 500’s current price to the earnings the index is expected to generate over the next 12 months, is also elevated. Right now, it sits at 22.2-times earnings, which rivals 2021 and dot-com era levels.

Another measure is the S&P 500’s price-to-book value, which measures the index’s price against the total value of its companies’ assets. The metric is at an all-time high, just surpassing the peak levels at the height of the dot-com bubble.

Finally, there is the so-called Warren Buffett indicator, which measures total stock-market capitalization relative to GDP. It’s currently at its highest level ever.

While high valuations can be concerning, they don’t necessarily mean stocks are destined to underperform. If earnings improve enough relative to share prices, valuations can fall.

“Buying stocks at these multiples feels bad, but there are good ways (sales/EPS/GDP booms) and bad ways (price declines) to resolve this seemingly untenable situation,” Bank of America’s top US equity strategist, Savita Subramanian, wrote this week.

“Or perhaps this situation is not untenable – the index has changed significantly from the 80s, 90s and 2000s. Perhaps we should anchor to today’s multiples as the new normal rather than expecting mean reversion to a bygone era.”

Those words sound like the infamous words from Yale economist Irving Fisher, who said just before the 1929 crash that stocks had reached a “permanently high plateau,” but Subramanian said that the S&P 500 is, in some ways, a higher-quality index today than in the past.

“In theory, investors pay up for predictable assets and are compensated for uncertainty. Financial debt is a source of risk, but today’s S&P 500 sports a lower debt to equity ratio than prior decades,” Subramanian wrote. “Earnings volatility has decreased: companies with high S&P quality ranks make up more than 60% of the index, up from <50% in the 2000s.”