The S&P 500 hovered around the 5,000 mark this week, supported by improving earnings, but market valuations have begun to look hefty.
According to FactSet, the performance of the S&P 500 relative to earnings estimates continues to improve as more companies release their financial statements.
As of Feb. 9, the percentage of S&P 500 member companies reporting positive earnings surprises was above the 10-year average, though the magnitude of earnings surprises is still below the 10-year average. "This suggests that companies are generally performing better than expected, which is a positive sign for the market," Michael Schmied, a financial consultant at Kredite Schweiz, told International Business Times.
But valuations have started to become stretched. FactSet, which monitors the financials of the S&P 500, finds that as of Feb. 8, the 12-month forward P/E ratio for the S&P 500 reached 20.3%.
That's above the five most recent historical averages for the S&P 500: 5-year (18.9), 10-year (17.7), 15-year (16.1), 20-year (15.6), and 25-year (16.4). In addition, FactSet points out that the last time the forward 12-month P/E ratio had been above 20.0 was Feb. 9, 2022 (20.2), when the market was heading south.
Still, a PE above 20 doesn't necessarily mean that the market is overvalued, as the current PE is still below the peak P/E ratio of the past 25 years for the index of 24.4 recorded on July 16, 1999.
Stephen Taddie, Chief Economist at HoyleCohen, LLC, thinks the stretching of the S&P 500 valuation signals that markets bet on higher future earnings to close the valuation gap.
"Earnings should be able to support S&P 500 5,000+, but current valuations for the index have become a bit stretched," he told IBT. "Earnings growth expectations for 2024 have not budged in about 12 months. Looking ahead at 2024 and 2025, analysts expect an 11-13% EPS growth. The market bets that future earnings fill the gap created by rising stock prices."
Taddie reasons that the market's optimistic bet is based on higher productivity and labor cost cuts, which have not yet been diffused through the system. "A combination of applied AI and reduced headcount should provide more fuel for advancing productivity," he added.
In addition, corporate earnings could get a boost from the resilience of the U.S. consumer. "Two pillars of strength have emerged, rising "real" incomes and the benefits of fixed rate residential real estate investment," he explained. "The combination has been at the core of the economy's continued growth."
Meanwhile, Taddie points out that earnings and price appreciation have been all about the Fabulous 5, the Magnificent 7, and the Top 10 in the past few years. "Earnings growth and valuation expansion outside of the narrow list of names have been hard to come by," he said.
Vijay Marolia, a money manager with over 20 years of capital markets experience, agrees. "Let's not forget the vast majority of Earnings growth (as well as stock price performance) was due to ONLY 7 stocks—the other 493 have negative earnings growth," he told IBT.
Marolia, too, believes that S&P 500 valuations are getting stretched. "While traditional valuation ratios like PE, PEG, & PB don't seem too far above the norm, more strategic valuation metrics like Robert Shiller's CAPE ratio (which measures price-to-earnings on a cyclically adjusted basis) are showing values higher than 96% of the data going back to 1881," he said.
Schmied urges caution, as any negative surprise in earnings or economic indicators, could lead to a market correction. "As always, a diversified investment strategy and careful risk management are key in such scenarios," he added.
