How expensive are US equities?

Here are the bull and bear cases.
 

The bear case

Let’s begin with the bear case, which is far easier to make. This analysis from Leuthold Group shows that valuations are highly elevated by historical standards on a variety of metrics.
 

NYU Stern finance professor Aswath Damodaran, who is considered to be the dean of valuation, published his latest analysis of the equity risk premium (ERP). He calculated the ERP to be 4.23%, which is somewhat compressed by historical standards. For some perspective, the ERP at the start of 2022 was 4.24%, and 2022 was a negative year for the S&P 500.
 

Damodaran appeared in a CNBC interview soon afterward on the day before the CPI report and said that inflation, which is a key driver of the bond market’s risk premium, will determine where stock prices go for the rest of this year.

As a reminder, PCE is the Fed’s preferred inflation metric. In the wake of the hotter-than-expected March CPI but cooler-than-expected PPI reports, the Cleveland Fed’s nowcast of March core PCE is 0.3%, which is likely to keep the Fed on hold for the time being.
 

A glass half full?

That said, the outlook isn’t totally dire. Despite the market’s pivot to more hawkish expectations of rate cuts, the March FOMC minutes revealed a silver lining that a taper of quantitative tightening is just around the corner: “The vast majority of participants thus judged it would be prudent to begin slowing the pace of [balance sheet] runoff fairly soon”, which would provide greater liquidity to the banking system and create tailwinds for equity prices. However, “all participants emphasized the importance of communicating that a decision to slow the pace of runoff would have no implications for the stance of monetary policy”.

So are stocks cheap or expensive?

Mostly, Subramanian makes the point that the quality of S&P 500 companies has improved over the years. Lower-quality stocks with high interest risk have lagged and duration, or interest rate sensitivity, of the S&P 500 has fallen, which makes the stock market more resilient to a higher rate environment. Moreover, megacap growth stocks have become more profitable. They restructured to contain costs in early 2023 and they began to pay dividends and buy back shares to return more immediate value to shareholders.

Do valuations matter?

At the end of the day, the valuation debate is moot unless you have a long-term time horizon. Analysis from JPMorgan Asset Management shows forward P/E ratios only have a weak inverse relationship with returns on a one-year time horizon, though the relationship is tighter on a 5-year time frame.
 

Valuation doesn’t matter until it matters. My analytical framework depends on a combination of valuation and macro and technical analysis. The last two factors tell me whether the stock market might rise or fall. If it were to fall, valuation tells me how far it falls.
 

From a tactical perspective, the market and economy are undergoing mid-cycle expansion. P/E expansion has elevated stock prices, but as long as earnings estimates rise, downside risk should be relatively limited.
 

A St. Louis Fed study that estimated productivity gains from past technologies, as well as the pace of technology adoption, was eye opening. The researchers concluded that the productivity effects of AI adoption will be relatively slow by historical standards and compared it to PC and cloud computing:

This accompanying chart shows the pace of cloud computing adoption.
 

The accompanying chart summarizes the trade-off between value and fundamental momentum. There are much better values in non-U.S. markets, but the U.S. is a standout on earnings estimate revision. Japan looks like a bargain on both historical valuation and earnings and that market has recently achieved new all-time highs, but continuing weakness in the Yen has been a drag on returns for foreigners.