It has been a volatile four months with big ups and downs, and the U.S. stock market is still technically in a bear market, meaning it hasn’t recovered to its highs set in September 2018.
Despite that, many valuation metrics show that U.S. stocks are still expensive based on their own history and compared to the rest of the world. This article provides an update on equity valuations based on a variety of different metrics.
Price-to-Earnings and Price-to-Book
U.S. stocks continue to trade at a big premium relative to foreign stocks. This Vanguard chart compares valuations of the S&P 500 (which the C Fund tracks) vs foreign developed markets and emerging markets:
This chart has about a 1-month lag, so the actual numbers are a bit higher thanks to the big rally global markets had in January. The S&P 500 price-to-book ratio is now over 3x, which means it’s the highest it has been since 2002 except for late 2018 when it was a bit higher.
The price-to-earnings ratio is measured in years, meaning it’s the number of years it would take to earn back your investment assuming no growth. For example, if the price-to-earnings ratio of a stock is 16, it means that based on current earnings it would take 16 years of earnings to pay for the initial investment.
Many companies grow their earnings over time, so the payback period is usually quicker.
The shortcoming of the price-to-earnings ratio is that it only takes into account the past year of earnings. During economic peaks, the price-to-earnings ratio can be surprisingly low because earnings are temporarily high, and during recessions the price-to-earnings ratio can be surprisingly high because earnings are temporarily low. Thus, it’s not a very reliable indicator for when to buy or sell.
A more reliable metric than the pure price-to-earnings ratio is the cyclically-adjusted price-to-earnings ratio, popularized by Yale professor Robert Shiller. This metric divides the current price by the inflation-adjusted average of the past ten years worth of earnings.
Based on this metric, although we’ve come down a bit from September 2018 highs, stocks are very expensive. Only in the year 2000 have stocks been more expensive.
However, the impact of corporate tax cuts mitigates this to some extent. Out of the past ten years of earnings, nine of them are under a higher tax rate than what companies have going forward. The tax-adjusted Shiller ratio would be a bit lower, perhaps in the mid-20’s. Still high, but not quite as outrageous as the chart may imply.
Price to Sales
In many ways, the price-to-sales ratio is the hardest metric to manipulate. Corporations have many ways to “manage” their earnings per share through share buybacks, tax rate changes, and various accounting tactics, but raw revenue simply is what it is.
The price-to-sales ratio compares current stock prices to the past year of revenue.
Based on the price-to-sales ratio, stocks have never been more expensive than the past few months, even during the Dotcom bubble in 2000. This is partly because stocks are expensive, and partly because corporations have the highest profit margins in decades.
Market Capitalization to GDP
The final metric discussed here is the total market capitalization of U.S. stocks (the total price for all shares of all U.S. companies) divided by the GDP, which represents the size of the national economy. When stocks get expensive, the stock market historically grows much larger than GDP.
This metric reached a height of nearly 150% in 2000 and fell to 75% two years later as the stock market dropped by about 50%. Then, stocks recovered and rose back to about 110% of GDP in 2007 before falling to about 60% during the financial crisis in 2009. Then, they recovered up to nearly 150% again in September 2018, tying the highest level on record. It has since fallen to 125%, which is below its all-time highs but still above recent historical norms.