How high is too high?
As we cruise through earnings season, with the S&P 500 Index (SPX) valuation at a historically high level according to some metrics, many investors are starting to nervously ask that question. Should these elevated valuations be a warning signal to the investors who keep pushing stocks to record highs?
The answer depends on a number of factors.
Look Toward the Future, Not the Past
Nobody knows where the market will go, and this might be a good time for some investors to consider their portfolio allocations to decide how best to proceed. But the market tends to be forward-looking, meaning that the prices of today’s stocks are often valued based upon what market participants believe might happen in the future.
One of the things that could happen in the future is an increase in corporate earnings growth, which could lower P/E ratios—a traditional metric for valuation—and make today’s valuations look more reasonable in hindsight.
“Although valuations seem high from a historical perspective, and investors should strike a note of caution from that as they make their investment vehicle choices,” says JJ Kinahan, chief market strategist at TD Ameritrade. “There is another school of thought—some of these prices may be previewing earnings.”
In other words, the market may be pricing in some soon-to-be-announced earnings growth. “That is, as we have had such a low-growth economy for so long, prices may be breaking out in anticipation of a follow-on from earnings,” Kinahan says. He says the exciting thing is, we’ll get a preview of this theory as earnings season continues.
More Factors to Consider
Low interest rates and inflation have been drivers of corporate profitability. If they continue at the same levels, profitability may continue to grow.
But it’s not just a good economic climate that could power increased earnings. There's also hope on Wall Street for some sort of U.S. tax reform, although there's no guarantee that this will happen, what exactly it might consist of, or how long it might take to implement.
If there were changes to the tax rate, then there's the potential that lower corporate taxes, lower costs, higher profits, and more capital available to put toward growth could all lead to higher corporate earnings.
But what if corporate earnings don’t expand? Does that mean stock prices would have to drop to get back to historical valuations? Not necessarily.
Across the global markets, there are trillions of dollars in investment capital that need to be allocated for individuals, institutions, and even governments. But there are only so many asset classes that they can be put into.
Two of the main assets these investment funds flow into are stocks and bonds. But with the current low-interest climate, bonds have underperformed the stock market.
If the market believes that rates will stay low and bonds will continue to underperform, it’s possible that money could continue to move into stocks, driving them higher—regardless of the valuation.
A high stock market valuation is not necessarily a predictor of what will happen, but instead it could be more like a caution sign—one that should warrant your attention, but not necessarily your worry. Consider using it as an opportunity to make sure your portfolio is allocated in a way that suits your objectives.
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