While day after day we are bombarded with musings from talking-heads proclaiming that no matter what happens in the future, buying stocks and buying more stocks is the way to go, the data has a different story to tell. As Goldman Sachs notes, at a forward PE of 17.5x, the equity market looks more expensive today than it was during any of the last four cycles. Furthermore, as Goldman puts it, we find it more challenging to rationalize the current high PE multiples.
Via Goldman Sachs,
The PE ratio for the S&P 500 based on a 4-quarter trailing sum of earnings currently stands at 18.1x. This compares to values of 13.6x, 16.1x, 29.0x and 19.1x at the start of the last four hiking cycles, respectively. When the PE ratio is based on an estimated 4-quarter forward sum – which is the valuation metric preferred by our equity strategists – equities look even more expensive. At a forward PE of 17.5x, the equity market looks more expensive today than it was during any of the last four cycles except for hikes than began during the tech bubble of the late 1990s.
In contrast to Treasury term premia, for which it is easy to tell “fundamental” stories that can explain why the term premia are low (even if we declined to attempt this empirically), we find it more challenging to rationalize high PE multiples. A fundamentally-based argument would need to argue that relative to past rate-hike cycles, some combination of the following three factors would presumably need to hold true: that expected growth is higher, equity risk premia are lower, and/or risk-free discount rates are lower.
Of these three possible arguments for high PEs, the latter is the easiest to make, because long-run risk-free interest rates are, in fact, extraordinarily low. Indeed, it is common to hear that equities are the “least-bad” investment option in such a low-yield world, which is just the colloquial version of the valuation math. That said, if term premia are low due to low and falling inflation risk, and if equities hedge inflation risk better than fixed-coupon bonds, then the drop in term premia doesn’t necessarily imply higher equity PE multiples. The links between bond premia and equity premia are subtle; one needn’t imply the other.
The remaining ways to justify a high PE are to argue either that long-run potential growth rates for real GDP or that equity risk premia are higher today than in past rate-hike cycles. While growth expectations are difficult to judge, it’s our view that the poor growth performance of the post-crisis period has done more to foster pessimism than optimism; “secular stagnation” is the theme du jour.