(Yahoo!Finance) - With the S&P 500 (^GSPC) closing at a record high this week, a debate on Wall Street has predictably broken out over whether stocks are overvalued.
But multiple strategists told Yahoo Finance this week that market history shows these fears are ultimately misplaced.
"When we look at the relationship between the market's multiple and forward returns, it's nonexistent," Citi US equity strategy director Drew Pettit told Yahoo Finance. "The correlation between returns and PE is almost zero over the past 20 years."
The S&P 500 is currently trading at a trailing price to earnings (PE) ratio of about 22, according to recent work from Citi. That lands in the 92nd percentile for the S&P's typical valuation over the last 20 years.
Citi's equity strategy team said this valuation is a "common pushback" to their constructive outlook on stocks. Citi's team led by Scott Chronert sees the index closing the year at 5,100; on Friday, the S&P 500 closed at 4,891.
BMO chief investment strategist Brian Belski agrees.
He prefers not to make valuation calls because they're a "trap."
"Valuation is actually the worst metric for future performance," Belski said. "Too many people are looking at the market and they want to make these broader market calls. And they're not kind of looking at the underlying components of the market. You know, after all, the stock market is a market of stocks; you don't buy the entire market."
To this end, Citi argues that even if lofty valuations were to be used as reason to not buy stocks, comparing the S&P 500's valuation now to earlier points in history is akin to comparing apples to oranges.
Pettit points out the composition of the S&P 500 isn't the same as it was 10 or 20 years ago due to the quarterly rebalancing of the index that kicks out sputtering companies and adds up-and-comers. For example, Uber was added to the index in December. Shares of the rideshare giant are up 5% over the past month.
"There's more growth in that valuation now than there used to be," Pettit said, nodding to the increased position of technology in the index.
To Pettit's point, seven large cap growth stocks — the so-called "Magnificent Seven" of Apple (AAPL), Alphabet (GOOGL, GOOG), Microsoft (MSFT), Amazon (AMZN), Meta (META), Tesla (TSLA), and Nvidia (NVDA) — drove most of the S&P 500's gain in 2023.
And during the stock market's recent rally, nearly 90% of the growth seen in January has also been driven by the same tech companies, excluding Tesla, per analysis from Yahoo Finance's Jared Blikre. All of those companies trade at valuations higher than the S&P 500.
These six leaders are also expected to account for more than all of the index's earnings growth in Q4, with earnings for this group forecast to rise 53.7% over last year against a 10.5% decline for the balance of the S&P 500, according to data from FactSet.
Citi's team also broke down a new valuation metric that compares individual company valuations today to the past, substituting in sector-specific metrics that matter most (such as book value for banks).
Using this valuation tool, Citi found the valuation of the S&P 500 stands closer to 19 (19.1, to be precise). This would put the valuation in the 78th percentile historically, and in line with a valuation range seen since 2016.
This, the firm believes, better segments the index into its constituent parts, similar to Belski's note that the stock market is, after, a "market of stocks."
With this valuation, Pettit says the S&P 500 is "not as expensive as it looks, but it doesn't mean it's cheap."
"At 19 times, it just means you need good earnings growth for the market to go up from here," Pettit said. "So as long as you think earnings are growing, going the right way you can pay 19 times for the stock market."
Consensus estimates are for S&P 500 earnings to grow nearly 12% in 2024, per FactSet's data. That would mark the largest jump in earnings since company earnings surged in 2021 amid the post-pandemic recovery.
"The rhetoric that is surrounding the stock market right now in terms of growth is that growth is going to slow," Belski said.
"It's the exact same story that was going on last year, same rhetoric ... There's actually no analytical evidence that we're seeing any kind of earnings slowdown."
By Josh Schafer · Reporter
