INSIGHTS

On August 28, 2017

AAM Viewpoints – A Closer Look at Valuation

Stretched valuations have become a common talking point in regard to domestic equity markets. This is a rather uncontroversial claim given the current bull market cycle is approaching 8.5 years and the S&P 500 is sitting near all-time highs. For example, according to Bloomberg, the trailing 12-month P/E (price-to-earnings) ratio for the S&P 500 is 20.98. This P/E ratio is above the 5-year average (18.18) and above the 10-year average (17.20). However, valuations alone do not necessarily create a binary buy or sell decision. P/E valuation-based indicators are often used as a sentiment indicator, with high valuations indicating high optimism and low valuations indicating pessimism. With the S&P 500 P/E currently above its 5-year and 10-year average, this begs the question, is there sufficient reason for investors to be optimistic?

I’d like to tackle this question in two parts. First, by addressing a structural objection. Second, by adding some context to valuations and the impact it has on equity performance.

As I mentioned earlier, the current bull market cycle, which began in March of 2009, is approaching 8.5 years. P/E expansion is typical through these periods, so it is logical that the valuation of the market today is higher than it was five years ago. In order to get a clear picture, historical averages that extend beyond the current bull market cycle would be preferred. The table below lays out some long-term averages along with some relative values we can use to compare:

Source: Bloomberg data, as of 8/22/2017

As you can see, the current P/E ratio of the S&P 500 is much closer to its long-term averages. The standard deviation over/under-valued column also helps frame the discussion. Recall observations within one standard deviation to either side of the mean account for 68% of the population. Therefore, a standard deviation of less than one represents something that is quite common or something that doesn’t deviate much from the norm.

Yes, valuations are above average, and the S&P 500 typically performs better when the index P/E ratio is below its historical average than when the valuations are far above average. However, just because performance is better when valuations are lower than average, it does not necessarily mean performance is bad (negative) when valuations are above average. In fact, the chart below shows the current P/E of the S&P 500 (20.98), although it is above average, is still at a level that is generally associated with positive equity returns over long-term horizons.

 Source: FactSet data

*60-month annualized total returns, measured monthly, beginning June 30, 1992.

Without going into too much detail, one could easily make the case for investors to be optimistic: the resiliency of the bull market, an uptick in global economic growth, strong corporate earnings, accommodative monetary policy, and possible corporate tax cuts on the horizon to name a few. Given these, we believe there is sufficient reason for the market to command a higher multiple and expect equity prices to continue to grind higher over the next 12 months as valuations alone, at this juncture, aren’t unreasonable given the market environment.