Regular readers know I have a love-hate relationship with narrow market laments. The same’s true of stretched multiple warnings.
Sure, it’s preferable for rallies to be characterized by broad participation, just like an economy’s generally healthier when more people realize the benefits of growth. But the US equity market, like the US economy, is defined by winner-take-all dynamics. Lamentable as that may be, it’s not necessarily an impediment to equity gains nor to economic growth in aggregate.
You can say something similar about valuation-based bear cases. It’s self-evidently preferable to buy things when they’re reasonably priced versus buying them when they’re overpriced, but the US equity market tends to trade at a premium to global shares and until very recently, that was no impediment to US outperformance.
With all of that in mind, have a look at the two charts below, from this week’s edition of Andrew Lapthorne’s popular weekly.
The figure on the right’s just a 35-year lookback on the forward index multiple. The figure on the left is more remarkable. “The substantial portion of profits continues to be generated by the top 10 US stocks, obscuring the broader picture, as outside this group, forward net income has shown zero growth over the past three years,” Lapthorne remarked.
In the same note, he said that although it makes sense in some cases to pay up for growth, “paying higher valuations for no growth suggests the increase in valuations is being driven by continued demand for equities rather than improving underlying fundamentals.”
Goldman’s David Kostin echoed that latter point in his latest. “A structural increase in equity demand from US households helps support today’s above-average valuation multiple for the US equity market,” he said, noting that households currently allocate almost half of their total financial assets to stocks, the most ever.
For Goldman’s clients, the biggest “pure markets” (if you will) concern is “a discomfort with the level of current valuation multiples compared with history,” Kostin said, noting that at 22x, the benchmark’s forward P/E is 97%ile since 1980.
The figure on the left, below, shows you how sensitive Goldman’s year-end S&P target is to multiples. Just a two-turn de-rating (to the five-year average) on the same forward EPS projection is worth 600 SPX points, for example.
But Kostin, who last week cautioned on narrow market breadth even as he lifted his S&P target, was keen to remind clients that trying to time markets based on breadth and/or valuations doesn’t generally pan out, or when it does, it’s just luck.
“During the past 45 years, there has been a very weak relationship between S&P 500 P/E multiples and subsequent six-month returns,” he wrote, referencing the scatterplot on the right, above.
Of course, valuations and, arguably, market breadth, matter quite a bit when it comes to projecting long-term returns from equity stakes purchased today. Simply put: If you buy stocks when they trade on multiples that count among the richest in recorded history and/or if you buy into a rally where participation’s limited to just a handful of high-flying mega-caps vulnerable to any downgrade of out-year growth projections, you’re stacking the deck against yourself.
As Kostin put it, “valuations may be a more useful signal for long-term returns, and history suggests that today’s valuation multiples should be associated with below-average returns during the next 10 years, all else equal.”
Should you fear narrow markets and ‘euphoric’ valuations?
No, as long as you can sleep with one eye open and have the ability to sell whatever before everyone else has R-U-N-D-E-D off.
Do. Not. Seek. The treasure.
This helps explains why we keep having V-shaped recoveries and buy the dip has worked because buying even a 5-7% discount in large-cap tech stocks is a no-brainer buy. Just like bitcoin or gold has a scarcity value, so do the best large-cap tech stocks, which have become a safe haven rather than consumer staples for example. Passive flows also keep a bid under the large cap tech stocks.
I recently read a piece saying that, along with the higher level of demand for equities, the market today contains proportionately more investors, than years ago, with a higher risk profile.
H-Man, always a matter of context, are you long or short the market? If your short, narrow markets and “Euphoric” valuations are your friend. If your long, it may be time to rethink things depending on your time horizon, you may want to adjust or simply hold the course and bulldoze ahead. It being understood that you never know exactly when a “Euphoric” valuation is no longer euphoric.
The daily question for investors; are we or aren’t we in Kansas.
It’s one of those basic assumptions we have but — short-term returns can’t be predicted based on valuation but long-term returns can to an extent. The data over the long term includes various idiosyncratic crises which are one-off in nature. What’s the causal relationship thought to be like? Equities have further to fall, or high valuation indicates excessive optimism? If you use 10- or 20-year windows then rolling 10-year returns from the same asset produce non-independent observations (eg. dotcom bust and gfc featured in data multiple times and preceded by high CAPE) but if you use independent observations then you have very few datapoints (eg. 5 separate 10-year periods with 1 ongoing since 1980, per asset) from modern markets. If the difference vs. static buy and hold is small, tax drag and suboptimal strategy execution could easily wipe out the difference. For the well informed people, what does the literature on this say?
Today XLK +1.1% while every other sector ETF down -0.5% to -1.7% . . . is this what narrow euphoria looks like? Me no like.