Six months ago, the average investor might have been content to pay $5 for every dollar of future earnings from the S&P 500. Today, that same investor seems willing to pay substantially more, a shift encapsulated in the current financial climate.
As of the latest data, the price-to-earnings ratio for the S&P 500 has climbed to 20.57, a significant increase from the October low. This type of jump in the index's valuation is a rarity, occurring just 5% of the time over the past three decades, according to David Rosenberg, a prominent market strategist.
Typically, corporate profits and valuation expectations should align closely in a stable market. However, for 2024, the S&P 500 is projected to earn $243.33 per share, slightly more than earlier estimates. This adjustment poses a critical question: why are investors prepared to pay more?
The dilemma facing this year's market revolves around valuations that have soared past the 25-year average. Despite some leading strategists deeming these levels unsustainable, they continue to adjust their market forecasts upward, possibly succumbing to the prevailing bullish sentiment.
Mike Wilson of Morgan Stanley acknowledges this trend. "Our predictions for the profit-to-earnings ratio over the last year have been imprecise, and though we are certain that valuations are overly inflated, predicting when or how they will correct is challenging," he stated, subsequently raising his 12-month S&P 500 target to 5,400 from 4,500.
A key driver of these high valuations is liquidity. There is a significant amount of money available for investment, as evidenced by record-high money-market fund balances, which surpassed $6 trillion in February. This liquidity, including substantial sums in short-term debt instruments ready to be funneled into equities, helps bolster market valuations. Additionally, other liquidity indicators, such as the $440 billion in the overnight reverse repurchase facility and the $21 trillion M2 money supply, suggest a healthy financial environment conducive to risk-taking.
A significant portion of the S&P 500's valuation increase is attributed to the tech sector, driven by enthusiasm for developments in artificial intelligence. Leading tech companies—Nvidia, Apple, Amazon, Microsoft, Google’s parent Alphabet, Tesla, and Meta Platforms—are trading at a collective P/E ratio of 30.71 over the next 12 months. This figure not only represents a 3.8-point increase since October but also exceeds their 10-year average, underscoring the tech-heavy skew of the S&P 500’s overall valuation.
This is contrasted by the S&P 500 Equal-weight index, which assigns identical weight to each constituent stock and is currently trading at a P/E of 16.31 times future earnings. While this is an increase from October, it aligns with the 10-year average, indicating a more normalized valuation across a broader array of companies.
Moreover, the market's momentum might be keeping investors engaged longer than anticipated. The S&P 500's frequent ascension to new highs—24 record closings in the first half of the year alone—compounds this effect, with limited selling pressure forcing buyers to offer increasingly higher prices for earnings shares.
However, this market enthusiasm, often detached from economic fundamentals, mirrors the "irrational exuberance" that Alan Greenspan critiqued in 1996. David Rosenberg reflects this sentiment, pointing out that the current market dynamics are more about sentiment and speculation than economic reality. This disconnection suggests that equities might be significantly overvalued, exposing them to potential corrections should inflation escalate or if earnings from key AI-driven companies fall short of expectations.
