By Compass Contributor
Copyright caymancompass
US equity valuations are currently around 23 times forward earnings. This price-to-earnings (P/E) ratio is substantially higher than the historical average of 17 times and ranks in the 95th percentile since 1990.
Professor Robert Shiller maintains a database of historical valuations. He prefers to use real 10-year averages to smooth earnings over a business cycle. This method shows cyclically adjusted valuations at an even more extended 38 times earnings, compared to a long run average of 18 times, or 98th percentile.
There are other measures of equity valuations, but they all tell a similar story.
High valuations are not new. Shiller’s measure has averaged 31 times in the last decade, compared to 24 times in the prior 30 years. There is no relationship between valuations and short-term stock market returns, as factors like sentiment and earnings revisions are more important.
While valuations are a key determinant of future long-run returns, even this relationship has weakened over the last decade. US equities have continued to deliver strong returns, even with starting valuations elevated versus history.
This time is different?
Therefore, an important question for investors is: to what extent are higher valuation multiples justified?
This question is haunted by a ghost of the past.
In October 1929, economist Irving Fisher famously declared that the stock market had reached a “permanently high plateau”. Two weeks later, the stock market crashed and the Great Depression started. Other calls of “new paradigms” for valuations have been similarly ill-timed.
However, there are some persuasive reasons why valuation multiples today are structurally higher than in the past.
Firstly, the structure of the economy has changed. In the last 40 years, there have been four recessions, compared to eight in the 40 years prior. The US has spent 40 months in recession in the last 40 years, versus 96 months in the 40 years prior to that, or 8% of the time, versus 20% of the time.
A shift from manufacturing towards services helps explain this. Services are less volatile and not subject to large inventory swings like manufacturing. Central banks have also supported economic growth and helped anchor inflation over recent decades.
Corporate profit margins are another important factor. In theory, margins are very mean-reverting, as competitors, employees, customers and suppliers all exercise power over time that keeps margins in check.
However, since the mid-1990s, margins have seen a structural shift higher. Operating profit margins for the S&P 500 have risen from 6% to closer to 13% today. This has coincided with the rise of globalisation and successive waves of technological innovation.
Structural shifts boosting US equities
Like the economy, the composition of the S&P 500 has shifted over time. The technology sector, plus Amazon, Alphabet and Meta, now totals a huge 43% of the index.
This is similar to technology, media and telecoms at the peak of the dot-com boom, but valuations are closer to 30 times today versus 50 times in 2000. Profit margins in the sector have risen materially, from 11% in 2004 to 28% today.
Profit margins for software, hardware and semiconductors have all increased. Winner-takes-all industry dynamics have been key. Large technology companies have become global platforms dominating industries, like cloud computing, online search, social media and online advertising.
Technology has been highly scalable, often with little additional capital. Hardware is less scalable, but Apple is effectively a high-margin consumer staples business – historically, a rare combination.
Lower taxes are also a factor.
The effective tax rate for the S&P 500 has fallen from around 35% in the mid-1990s to around 20% today, driven by corporate tax reform and globalisation.
Lower bond yields have also helped support equity valuations. The S&P 500 P/E ratio fell into single digits in the 1970s, but that was around the time when the 10-year US treasury yield was hitting double digits, versus 4% today.
Supply and demand factors have also supported valuations.
Companies have been active in buying back shares, while IPOs have been restrained as companies stay private for longer or get acquired before listing.
Government budget deficits mean private sector and foreign surpluses, with some of this money finding its way into equities. Some global central banks now even own US equities. The last five years have also seen a resurgence in retail investor participation, after a prolonged period of apathy after 2008.
Overall, structural shifts mean that some measures of equity valuations are now flawed. Price to book does not account for increasingly important intangible assets, while market capitalisation relative to US GDP does account for globalisation. That said, valuations remain a key determinant of long-run returns.
Markets are currently supported by upward earnings revisions, resilient economic growth and lower interest rates. The challenge is that, at 23 times earnings, there is little room for disappointment, partially in themes like AI.
Some of the factors supporting valuations have also reversed; bond yields are higher than 2021 lows, globalisation is in retreat, and AI requires a lot of capital. Cycles, fear, greed, and volatility will always be a feature of financial markets, but it is also worth considering that structural factors support equity valuations above their historic averages.
Disclaimer: The views expressed are the opinions of the writer and, whilst believed reliable, may differ from the views of Butterfield Bank (Cayman) Limited. The Bank accepts no liability for errors or actions taken on the basis of this information.
Nicholas Rilley, CFA, is an investment manager and strategy analyst at Butterfield Bank (Cayman).
