Stocks Are Pricey, Again. Why You Shouldn’t Expect Big Gains Soon.

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Traders at the New York Stock Exchange.

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Stocks are pricey, again. A sharp rebound does that. But now, sustainable market gains might be hard to come by for a while because of something else that is high—earnings multiples.

First, the big picture: The S&P 500 is up about 10% from March 8, when it fell to its lowest closing level of the year and entered correction territory.

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And the bounce comes despite the fallout from the Russia-Ukraine war—a US ban on Russian oil that has pushed down supplies and pushed up prices. The added cost is hitting Americans at the pump, adding to the red-hot inflation triggered by households flush with cash and companies struggling to meet the demand with enough supply.

Even before the war, the Federal Reserve decided to reduce its bondholdings and expects to raise interest rates 10 more times within the next couple of years to bring down inflation, a move that probably will slow down economic growth, too.

Yet, against this backdrop, stocks have gained—and their earnings multiples have climbed. An earnings multiple is a stock’s price divided by its expected earning per share. An example: a $100 stock has a 20 times multiple if EPS for the next year is expected to be $5. The S&P 500’s aggregate multiple on expected earnings per share for the next year is roughly 20 times—up from this year’s low of 18 times.

A 20 times multiple is high for a couple of key reasons. First, February was the last time that the aggregate multiple was 20 times—and the S&P 500 was still on its way down. But since then, bond yields have risen, in part as a response to inflation. Higher rates on long-dated bonds make future profits less valuable, which often means a lower earnings multiple on a stock.

Another way to gauge whether multiples are too high is by comparing stock valuations to bond yields, using a metric called the equity risk premium.

At 20 times earnings, every dollar of S&P 500 earnings yields the investor 5%. The 10-year Treasury yield is at 2.32%. The annual yield on the stock market then is about 2.7 percentage points higher than the annual yield of the government bond.

The higher yield on stocks can be explained simply: Investors are demanding a premium return in return for taking the additional risk. Still, to be clear, that 2.7% risk premium is a historically low excess return—roughly where it tends to bottom since the end of the financial crisis, according to data from investment bank Morgan Stanley,

In times of economic uncertainty, investors often demand a more than 4% extra return on stocks versus bonds, a premium return that would force stock prices lower from here.

“It makes little sense for the equity risk premium to be at post Great Financial Crisis lows given the heightened risk to earnings growth,” wrote Mike Wilson, head of US equity strategy at Morgan Stanley.

To be sure, though, none of this means the stock market is necessarily in for another correction—just that big gains in the short term probably are a stretch.

“At a 20 multiple, I don’t think the risk reward is that compelling” for the S&P 500, said Keith Lerner, co-chief investment officer at Truist,
a commercial bank.

Others agree with Lerner.

“Today we are saying chasing the market higher is tough,” wrote Dennis DeBusschere, founder of 22V Research, an investment research firm.

Right on cue, The S&P 500 is stumbling as it reaches this high valuation level. Earlier in the week, the index closed just above the 4,600, or roughly 20 times earnings. It has fallen since then and is now just under 4,600—the same level for two big selloffs in February.

High anxiety about economic growth explains the drop. Analysts could potentially lower earnings estimates if the economy falters enough.

So, high stock prices, high earnings multiples, equity risk premium, economic uncertainty: Is there anything investors can feel good about?

There is. Investors probably won’t be paying any higher of a premium price to own stocks than they are paying now.

Write to Jacob Sonenshine at [email protected]


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