A “Rational” Basis for Supporting Today’s Stock Market Valuation

With the S&P 500 trading at an historically high 19X estimated 2020 earnings many stock market commentators have raised a cautionary flag about today’s stock market valuation. They may, of course, be correct but something more fundamental maybe going on that would justify an even higher price/earnings ratio.

In December 1995, when I was chief equity strategist at Salomon Brothers, I penned a piece entitled “1996: Stock Market Bubble or Paradigm Shift?” In that piece I argued that there were two prior valuation shifts within the memory of investors at that time. The first one was in 1958 when dividend yields fell below bond yields for the first time since 1929. My explanation and also Ben Graham’s in 1962 was that investors then realized that Keynesian policies would prevent depression thereby making stocks much less risky allowing the P/E ratio to expand 13X to 18X.

The second valuation shift took place in 1974 when investors witnessed runaway inflation in the presence of high unemployment. Their faith in Keynesian economics was broken and instead of depression, inflation became their biggest fear. By 1979 the P/E ratio collapsed to 6.5X.

As I argued in 1995 a third valuation paradigm shift took place that year. Simply put 14 years after Paul Volcker broker the 1970s inflation, the inflation trauma that investors so feared was healed. With inflation fears in abeyance P/E ratios on current earnings could rightly expand to a 14X-17X range and to 16X-20X trend earnings. Of course investors got carried away in the dot.com boom temporarily taking the P/E multiple up to 30X by late 1999.

Subsequently a fourth valuation shift took place in 2008 when investors became so complacent with the Great Moderation orchestrated by the Fed excessive risk taking in the fixed income and derivative markets nearly brought the economy to its knees reviving fears of a new Great Depression. To revive the economy the Fed through caution to wind and adopted a host of measures to maintain liquidity in the banking system and established a regime of extraordinarily low interest rates well past the crisis years of 2007-2010. When the initial shock passed multiples returned to a more normal 12X-15X earnings.

So what do we make of today? We could be cruising to another bubble where excessive risk taking brings the economy down or, alternatively, investors now expect that the very low interest rate regime of the past decade will be permanent just as investors in the 1960’s believed that Keynesian economics would keep depression away and investors in the middle 90’s that the moderate growth-low inflation environment would last forever.

It seems that investors now believe that the Fed, after learning the lessons of 2019, will have a very high bar to raising interest rates in the future and because the fear of deflation is stronger than the fear of inflation 10-Year Treasuries will be locked in a narrow range of 1.5%-2.5%. I am not sure I buy into all of this, but if my thesis is roughly true it would not be too difficult to envision P/E multiples in the 20X-25X range. Thus using, say a $185 earnings for the S&P 500 in 2021, and placing a 22.5X multiple on those earnings you end up a with valuation of 4100-4200. This valuation is not my forecast, but it does make for a plausible bullish case which rests on inflation staying low.