Is the U.S. stock market too expensive?

Global equity markets have spent the past month adjusting to the view that the U.S. Federal Reserve may be nearing the end of its rate cutting campaign. Nevertheless, markets experienced some renewed strength over the past week after a subdued early start to the year. A combination of strong employment figures and lower than expected inflation readings proved to be a catalyst for a return of some enthusiasm. Below, we discuss the drivers of market performance and why the earnings trajectory may become increasingly important over the next few years.

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Stock markets tend to be driven by two factors: the earnings from the companies within the market and the value that investors are willing to subscribe to those earnings. The former tends to ebb and flow along with the upswings and downswings of the economy. The natural tendency for the economy is to grow, and earnings growth therefore tends to be more positive than negative. Valuations on the other hand are more heavily influenced by investor sentiment and can change, sometimes significantly, from one year to the next as investors anticipate whether conditions will improve or deteriorate in the future.

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The change in valuation for the U.S. S&P 500 index as measured by its forward Price to Earnings (PE) ratio was -22%, 17%, and 10%, respectively, across the past three years. Today, the forward PE ratio sits at 21, above its long-term average of 16, suggesting the U.S. equity market is expensive, though not at extreme levels. Excluding the mega cap tech group, the market’s P/E ratio is below 20, suggesting valuations for the rest of the market are not as expensive, but still above average. History has taught us that valuations can stay elevated for some time, sometimes for years. Moreover, valuations could move even higher as high prices often lead to even higher prices. In other words, there is still upside for U.S. stocks should investor sentiment with respect to the future become more positive.

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Yet, we believe the onus for future market gains is increasingly shifting to earnings because valuations are already relatively high. Earnings growth for the S&P 500 was roughly 3%, 6%, and 12%, respectively for the past three years. Much of the growth was fuelled by the large-cap technology stocks whose earnings growth has benefitted from the capital expenditures related to artificial intelligence. That trend is expected to change somewhat this year. While growth for technology is expected to remain robust, growth elsewhere is expected to broaden and accelerate throughout the year, leading to mid-teens earnings growth for the broad market over the next few years. Some of the tailwinds that are expected to benefit earnings include less regulation, lower taxes, and a subsequent reacceleration in economic growth.

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In summary, the U.S. market is not cheap. That alone does not present a problem as high valuations have historically not been helpful in informing us about what to expect from the market in the near-term. But it does suggest that expectations are high, particularly in some sectors, and that companies will have to deliver on the earnings expectations that are embedded in current market prices. That is one of the main challenges we see for the year ahead. As a result, we will be paying close attention during the earnings season that is now underway and will be particularly focused on the outlooks from company management teams.

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Should you have any questions, please feel free to reach out.