Are stocks too expensive? … how to answer that question for yourself … the bottom-line takeaway from our technical experts
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From all of us here at InvestorPlace, have a wonderful Labor Day weekend!
Moving on to today’s Digest…
***You’re going to walk away from today’s issue a wise investor
That’s a tall order, but I stand by it.
In this week’s Strategic Trader update, our technical experts, John Jagerson and Wade Hansen, tackled the question that’s weighing on investors today…
Are stock prices too high?
There are plenty of reasons to be anxious.
One, we’re at all-time highs… Two, the S&P 500 has climbed about 21% year to date, miles above the historical average annual return of about 10%… Three, in the first eight months of the year, the S&P hasn’t had a pullback of more than 5%… Four, last September, the S&P dropped nearly 10%, top to bottom.
So, are stock prices too high?
Today, we’ll find out John and Wade’s answer. But the part that will make you a wiser investor is following their methodology in arriving at the answer.
You see, John and Wade utilize a fantastic yet simple, step-by-step analysis that you’ll be able to use for the rest of your investing career. It provides a quick, logical, quantitatively-based snapshot of a stock market’s value.
So, today, let’s do our best to help you make money and make you a wiser investor.
Let’s jump in.
***The simple framework to help us price the market
For newer Digest readers, Strategic Trader is InvestorPlace’s premier trading service. It combines options, insightful technical and fundamental analysis, and market history to trade the markets, whether they’re up, down, or sideways.
But what about when markets are at all-time highs?
Returning to the question du jour, are stocks too high? So high, in fact, that we need to hunker down and prepare for a wipeout?
Well, to answer that, we have to ask a different question…
Too high relative to what?
Stocks aren’t the only game in town. Investors have bonds, real estate, cryptos, private equity deals, foreign assets, commodities, you name it…
At the end of the day, what an investor wants is the highest risk-adjusted return, or yield. So, how do traders assess their options from this perspective?
For more on this, let’s turn to John and Wade:
The baseline yields traders typically use when assessing their investment opportunities are Treasury yields – like the 10-year Treasury Yield (TNX) – because they know that Treasuries provide a reliable yield, backed by the full faith and credit of the United States government.
Treasury yields fluctuate as inflation, monetary policy, and economic growth expectations change.
Currently, the TNX is offering a paltry yield of 1.3%
So, 1.3% is our starting point. From here, investors can evaluate other investment yields.
***Since the question is whether stock prices are too high, let’s evaluate the stock market yield
How do we do this?
Back to John and Wade:
You look at the earnings yield – which is the earnings the market generates, compared to the price you are paying for those stocks (i.e. the E/P ratio).
If you’ve never heard of the E/P ratio before, you’re not alone. But even if you haven’t, it should look at least vaguely familiar. That’s because it’s the inverse of the P/E ratio.
So, to find the S&P’s earnings yield, we start with its P/E ratio and then just flip it.
John and Wade suggest going to a site like multpl.com to get the P/E. At the time of John and Wade’s update, the S&P’s P/E was 35.3.
Back to the Strategic Trader update:
Now that you know the P/E ratio, all you do is find the inverse of this number to determine the earnings yield on the S&P 500, which in this case is 2.8% (1 / 35.28 = 0.02834).
So, we have our baseline treasury yield of 1.3%. And we have the S&P’s earnings yield of 2.8%. But we’re not ready to compare them quite yet.
***Don’t forget to factor in dividends
Dividends play a huge role in the overall profitability of the stock market.
For some color on this, check out the chart below. Dating back to the 1930s, it shows stock market returns by decade.
The first number is the return from dividends. The second number is the return from price changes alone.
As you’ll see, dividends can be enormously important to overall returns.
So, what’s the dividend yield for the S&P 500 today?
Using multpl.com again as our resource, we find that it’s 1.3%.
Now, we combine the earnings yield (2.8%) and the dividend yield (1.3%) to get a total yield of 4.1%.
So, what does this mean? Is it good or bad?
There’s one final step we have to take before we reach our conclusion…
***Factoring in the historical risk premium
Back to John and Wade:
Traders try not to be foolhardy with these investments; they demand a premium for the increased risk they are taking by putting their money into stocks instead of bonds.
This “risk premium” is calculated by finding the total yield (earnings + dividends) a trader can earn from the S&P 500 and subtracting the TNX.
The risk premium can vary quite a bit depending on market conditions, but the average during the past 20 years has been 3.1% (see Figure 6).
Figure 6 – Risk Premium Since January 2000
John and Wade point out how the risk premium wasn’t as large during the bull market recovery between 2003 and 2008 (the left half of the chart above, when the blue line is staying beneath the orange “average” line).
This is mostly due to the Fed allowing interest rates to rise during this period. This allowed the TNX to remain higher, which reduced the risk premium.
But after stocks recovered in the wake of the global financial crisis, the risk premium jumped (the right half of the chart above, when the blue line is above the orange “average” line).
This is because the Fed kept interest rates near zero, even though stocks were climbing.
John and Wade note that the risk premium looks to be normalizing today. This reflects how traders are preparing for the Fed to eventually start raising interest rates again – likely by the end of 2022.
***Putting it all together, are stocks too high?
Now that we have all the pieces to the puzzle, let’s find out what it’s telling us.
Here’s John and Wade:
If a trader can earn 1.3% on her money by buying virtually risk-free 10-year Treasuries today and were to demand the average risk premium of 3.1% to invest in stocks, then those stocks would have to yield at least 4.4% (1.3% + 3.1% = 4.4%) to remain attractive.
When you compare the 4.1% return a trader could currently get from the S&P 500 with the 4.4% return an investor would demand if she could earn 1.3% on her money by buying virtually risk-free Treasuries and demanded a risk premium of 3.13% to invest in stocks, you can see the numbers are a little below average but are pretty close to where you would expect them to be.
So, are stock prices too high?
Average historical numbers suggest no. Yes, they’re high. But as you’ve just seen, the numbers aren’t grossly out of whack.
Sure, we could see volatility. In fact, September is usually a bad month for stocks, and given the surging market so far in 2021, it should surprise no one if the market turns red for a while.
Here’s John and Wade’s bottom-line, which will take us out today:
Traders keep wondering if the S&P can climb any higher as it hits new all-time high after new all-time high. After all, haven’t stocks gotten too expensive?
Based on our analysis above, we believe the current risk premium offered by the S&P 500 is still attractive, which leave the index plenty of room to run higher so long as the economic and earnings news remains positive and the TNX doesn’t climb too aggressively.
Have a good evening,
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.