Is the stock Market overvalued?

Over the last few months, there have been many market pundits that have been talking about the high historical valuation of the US stock market. The term bubble may be the most frequently occurring word used in many newsletters and chat rooms as of late other than GME. There are many ways to measure valuation in the market but the most common is the price earnings ratio (P/E). While the metric is useful as a broad snapshot for historical perspective, it is also very misleading as the price/earnings ratio is counterintuitive for multiple reasons. The P/E ratio is simply the price of a stock divided by the earnings of the company’s annual run rate of earnings. In other words a stock trading at $50 and has earnings of $4 for the current year, then the P/E ratio is 12.5. The current value of the S&P 500 is 3800 with a 2021 earnings estimate of $170 implies a P/E ratio of 22.4. This is above the high end of the historical range.

So, the first question to ask yourself is are u investing in the stock market or are you investing in a market of stocks? If you are a passive investor then you may use the value of a market to compare it against the historical range. As an active manager using some tactical strategies , an investor will want to value each company individually or reference prior valuations of specific sectors and similar companies. Another major input for valuation of the market and stocks are interest rates. At the most basic level, lower interest rates create higher valuations and higher rates tend to compress or lower valuations. The aggregate opinion of all market participants at a moment in time determine what that multiple will be as the “P” fluctuates vs the “E”. Price fluctuates while earnings continually gets revised up or down by market analysts as they adjust their projections from the guidance of the companies and their outlook.

ESG asset management considers valuation from a top down (market) and bottoms up (individual stock or sector) approach, however, valuation metrics are only one input of many in an investment decision. Currently, the “market” is historically expensive on an absolute basis but if you consider the level of interest rates (historically low) and the composition of the indices that are now more heavily weighted in sectors such as technology, healthcare, and consumer discretionary actually suggests a higher multiple in the overall market is appropriate. These sectors are naturally more expensive due to their growth prospects. Growth and industry disruptors and innovators are scarce and investors are willing to pay a much higher multiple for those types of investments. While this will not always be the case, it is what the market construct has priced in for the foreseeable future. There will be a push and pull of this dynamic as the shift from an analog society to a digital one will continue to make the technology sectors and almost every other sector transition toward digitalization and higher productivity. The advances in software, life sciences, semiconductors, cloud computing, deep learning, etc. is a boon for growth and society and it will have many disruptive and deflationary pressures on our economy. These forces will keep inflation muted or under control and interest rates should remain at historically low levels as long as inflation remains within the expected range. This set up will keep valuations elevated for quite a while. Furthermore, if valuation was the main determinant of a buy and sell decision in a broader sense, the returns on that strategy would be dismal at best. Be mindful of the mood of the the market while remaining humble and always continue to be a student of the market.

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