What Happens After S&P 500 Valuations Stretch

Over the last year, despite higher interest rates, the S&P 500 has surged by 28%, primarily propelled by a few large-cap growth stocks tied to the narrative of the AI revolution. At the same time, its P/E Ratio has increased by 29%. In other words, valuations have grown faster than underlying earnings, leaving the S&P 500's P/E ratio at around 24 at the end of February. This is not an all-time high, but places current valuations in the 87th percentile since 1980.

By other metrics, the S&P 500 appears more expensive. Below is the Price to Book Ratio of the S&P 500 since 1990, which has only reached these levels twice before: during the late 1990s Internet bubble and post-COVID. The current level of 4.68 positions the S&P 500's valuation in the 95th percentile.

Another way of assessing valuations is the dividend yield, shown in the next chart. Since 1999, dividend yields have undergone a secular shift lower as high growth, non-dividend paying firms have come to dominate indexes. Nevertheless, the current dividend yield of 1.4% is in the 12th percentile historically, not far from the lows.

It's also crucial to consider the role of cash rates and the changes in short-term cash rates as a driver of valuations. For instance, a 5% return on Treasury bills makes the risk premium of holding stocks over guaranteed cash returns less appealing. And the higher the returns on cash go, the less attractive stocks become. Below is a chart illustrating the 2-year changes in 3-month T-bill rates since 1980. As rates rise, cash has traditionally grown as a percentage of household assets. The recent increase in short-term rates put it in the 95th percentile, making current high stock valuations even more surprising.

Given that current valuations are high but not extremely so, what returns can investors expect over the next year, comparing current metrics to similar historical periods? In the table below we show what has happened over the next year to stocks when these measures were in comparable deciles.

Focusing solely on the more traditional valuation measures of P/E and Price to Book, the historical average or median percentage changes for the S&P 500 indicate modest single-digit or even negative returns going forward in the case of P/B. However, the range of outcomes has been vast, as you can see in the min and max outcomes. By contrast, projections based on current dividend yields or changes in short-term interest rates are more positive, though neither serves as an ideal gauge of stock market fair value.

It's important to note that some of these measures lack extensive historical data: P/B and Dividend Yield data only extend back to 1990. The Price to Book Ratio has only reached its current levels twice before. That said, the P/E ratio, a favorite tool for value investors, has a fairly long history. It suggests that future returns may be more subdued, with valuations normalizing eventually. What we can’t know is when. And as the late 90s tech bubble made clear, equities can wrap themselves around a compelling narrative like the Internet or AI, and go higher and for longer than anyone expects or can predict.

Data Source: Bloomberg

Make the most of these insights using Modelist. We create customized investment models for the fiduciary financial advisor. Get in touch with us at hello@modelist.me for a personal consultation.

Modelist Inc. is a registered investment adviser. Information presented is for educational purposes only and does not intend to make an offer or solicitation for the sale or purchase of any specific securities, investments, or investment strategies. Investments involve risk and, unless otherwise stated, are not guaranteed. Be sure to first consult with a qualified financial adviser and/or tax professional before implementing any strategy discussed herein. Past performance is not indicative of future performance.