In a reminder that stretched valuations make for poor timing signals, Piper Sandler strategist Michael Kantrowitz observed in a Monday note that the S&P 500 is overvalued to the tune of around 8% relative to the firm’s fair-value price-to-earnings ratio model. As Kantrowitz asks in the note’s title: “So what?”
The S&P 500 is trading at 21.8 times forward earnings estimates. “We’ve found that market multiples boil down to 3 variables: 1) interest rates; 2) credit spreads; and 3) index composition. An 8% over-valuation is no reason to get bearish. Stocks can remain at rich valuations as long as a ‘fear’ catalyst doesn’t arise from the usual suspects: interest rates, employment or inflation,” Kantrowitz wrote.
That said, there isn’t much upside for P/E ratios from here, he said, with earnings momentum not the stop stock-selection screening tool. Stocks with stronger earnings-per-share momentum are more likely to sustain or boost their valuation, he said.
When it comes to market timing and P/E ratios, Kantrowitz reminds that valuation isn’t a particularly useful predictor of forward returns, especially for investors whose time frames are measured in months or quarters rather than decades.
“While it is true that valuation is a decent predictor of forward returns 10 years out, we would argue this is primarily a function of the business cycle,” Kantrowitz said. “On average, recessions tend to occur roughly every 14 years. Following recessions you tend to see cheaper valuations followed by stronger returns.”