The stock market is incredibly expensive. Don’t run away now.

 The stock market is incredibly expensive.  Don't run away now.

The stock market is not only expensive, it is very expensive. However, history suggests that it could make amazing gains from the current level.


Standard & Poor’s 500

Nearly 15% for the year. It comes as investors increasingly expect the Fed to hold off on further interest rate increases, which are intended to cool the economy but pose a problem for stocks because the inflation rate has already fallen. Also helping the market is the fact that shares of major technology companies have risen on hope that artificial intelligence will make existing products more attractive and open the door to new ones.

The S&P 500 now trades at about 18 times the total earnings per share that its constituent companies are expected to earn over the next 12 months, well above the historical average of about 15 times. But this does not fully reflect how expensive inventories are, especially since the ratio has remained above 20 for long periods in the past.

Whether a stock’s valuation is insanely high has a lot to do with the level of interest rates. With the index trading at 18 times earnings, an investor can expect about $5.50 in annual earnings per share for every $100 they invest in it.

This 5.5% is only one percentage point more than the 4.5% or so investors can get from holding safe Treasury debt for 10 years. This extra return, known as the equity risk premium, is near a 20-year low, according to Morgan Stanley, and well below the long-term average of close to 3 percentage points.

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If the premium were at its historical average level, the dividend yield on the S&P 500 would be 7.5%. This equates to the index trading at 13.3 times earnings, well below the current level of 18 times – a sign that the stock market is frighteningly expensive.

However, history shows that when equity risk premiums are as low as they are now, stocks have tended to rise by double digits over the following year. When the risk premium for stocks in the S&P 500 ranges between zero and 1%, its average move for the following year is just over 12%, according to RBC.

When the equity risk premium is negative, with a stock return lower than the S&P 500, the index continues to decline in the following year.

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This is not what is happening now. There are plenty of reasons why people buy stocks even with a narrow equity risk premium.

Today, the market is confident that profits over the next two years will be much higher than Wall Street expected, in part because that is what has happened recently. The economy continued to grow, defying expectations that the Federal Reserve’s efforts to combat inflation would lead to a recession, helping earnings beat analysts’ estimates. Adding to the optimism are expectations that major technology companies will achieve annual growth in earnings per share over the next few years.

The likelihood of this favorable scenario occurring means analysts will eventually raise their earnings forecasts. If stock prices remain the same, the forward price/earnings multiple for the S&P 500 will be lower, making the market appear less expensive.

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Dividend yields will rise, while bond yields may fall, increasing the equity risk premium. The yield on 10-year bonds has already fallen by about half a percentage point from the multi-year high reached in October. Annual inflation is expected to average only about 2% over the next ten years, which implies that bond yields may decline.

“Downside momentum in 10-year yields should build (and that would be a tailwind for stocks),” Sevens Report’s Tom Isay wrote.

Investors are already looking at how to position themselves for this. Lori Calvasina, chief U.S. equity strategist at RBC, wrote Monday that in client conversations, “investors have been eager to explore what… [stocks] To own if returns peak.

Can stocks go up? This is a reasonable expectation.

Write to Jacob Sonenshine at [email protected]

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