The Equity Market May Be Expensive But We Don’t Know When The S&P 500 Will Sell Off

Recently, the S&P 500 is trading at a level not seen since early 1998, when the S&P 500 broke 1,000 for the first time. The market’s current normalized price to earnings ratio stands at around 29.1, the last time such a valuation was seen was in 1998, and the market went on to rally by 50%. There are only two periods in history when the equity market has been as expensive as it is today using a normalized price to earnings ratio.

Barring the dot-com bubble, the first occurrence of this anomaly was in 1929 when the market charged to a cyclically adjusted valuation of 30 times earnings before collapsing and starting the great depression. However, around 70 years ago when the market’s valuation returned to the same level, as noted above stocks went on to rally by a further 50%.

Put simply, based on past experience there’s a 50/50 chance equities will either fall or rally further from current levels.

The Equity Market May Be Expensive But…

A new research note from Alpine Capital Research considers this conundrum. Even though equity markets are relatively unpredictable, economic growth, which after all is the single most important driving factor for long term equity market returns, is more like a constant than an unreliable factor. Following the dot-com crash, the US economy grew year-over-year during the 2001 recession, which only lasted two-quarters and while the Great Depression was undoubtedly more severe regarding economic damage, in the 16 years after 1930, economic growth actually outpaced that of the 2000 to 2016 period.

As the US economy has proven resilient in the long term, ACR writes that it’s important to keep this steady base unchanged when calculating equity valuations. Specifically, the analysts note:

“We do not revise our long-term estimates higher when things seem better, nor reduce them when prognosticators turn pessimistic. Importantly, there is no historical precedent for making large shifts in long term economic growth assumptions when estimating future equity market returns.”

S&P 500 Selloff?

Unfortunately, while economic growth may be a constant, valuations are not. The correlation between evaluation and future long term equity market returns is high, as shown in the chart below.

ACR’s note goes on to say that rather than concentrating on the prospect of economic calamity, investors need to appreciate the historical data showing poor forward returns from equities trading at current valuations.

Equities have never produced steady total returns, but volatile returns that add up over time. It’s impossible to predict when the next downturn might take place (and the market may even go on to rally by another 50% from current levels) but what we do know is that the higher starting valuation, the lower the average long-term total return.