Stocks are a lot less expensive than they were two weeks ago. Unfortunately, they are still far from cheap.
The S&P 500 has fallen 10% from the record it hit last month, and if you want to point fingers at reasons why there are plenty of targets. Worries over how much the Federal Reserve will have to raise interest rates certainly helped get the tumble going. The wipeout in products that bet against volatility played a role as well. So might the automatic dumping of stocks by some so-called risk-parity funds. The expected swelling of the budget deficit as a result of tax cuts and a new budget deal certainly didn’t help either.
But the thing that made the stock market vulnerable in the first place was its price. At its peak last month, the S&P traded at 18.5 times expected earnings, according to FactSet, reaching its highest level since 2002. Since then it has fallen to 16.9. That is still high—the median level over the past 20 years is 15.2. Moreover, while for much of last year it was possible to argue that the market’s high forward price/earnings ratio was justifiable since it didn’t reflect the possibility of corporate tax cuts, that is no longer the case. Analysts have now largely incorporated them into their estimates. There is now even a worry they have been too optimistic, failing to recognize how much of the extra cash from corporate tax cuts will end up getting spent on wages and other costs.
No valuation measure is perfect, but other stock market yardsticks also remain rich. As a percentage of gross domestic product, the value of U.S. stocks remains near levels last seen in 2000, which by many measures was the most expensive period on record. The cyclically adjusted P/E popularized by economist
Robert Shiller
is at levels only eclipsed just before the 1929 crash and in the years surrounding the dot-com bubble.
The problem with high valuations when stocks falter is that they make it harder for investors to gain the confidence to step in and buy. Adding a further complication, rising Treasury yields are taking away the excuse many investors were offering for high stock valuations. Bonds are now a more viable alternative. Furthermore, since tax cuts and increased government spending seem likely to make an already tight labor market throw off more heat, the Fed seems unlikely to back off on raising interest rates for the sake of fretful investors.
None of this means stocks are doomed to keep on sliding, though they might. But investors have gotten a lot more nervous, and it seems that they probably should be.
Write to Justin Lahart at justin.lahart@wsj.com
