The U.S. stock market is currently experiencing levels of valuation that are reminiscent of the bull market top in early 2022. This conclusion is derived from a comprehensive review of eight valuation models, all of which have a strong track record in forecasting the U.S. market's future returns.
Despite the differences in these theoretical approaches, they all paint a similar picture of the current state of the U.S. market.
The diversity of these theoretical approaches is crucial since it allows for a comprehensive analysis of the market. By zooming in on specific indicators such as price/book ratios or q-ratios, we encounter various limitations such as inadequate GAAP accounting of intangible assets and the failure to account for corporations' preference for share repurchases over dividends. These limitations emphasize the importance of considering a broad range of indicators.
To counter the bearish implications presented by all eight indicators, bullish investors would need to demonstrate that each individual indicator is flawed. While this may be possible, it is a challenging argument to make and lacks plausibility.
In the chart below, we compare the current valuation of the S&P 500 (SPX, +0.99%) with the valuation levels observed at the peak of the bull market in January 2022. The columns in the chart represent the percentage of past months where valuations were lower, with higher columns indicating higher relative valuations.
Regardless of the comparison period chosen (2000, 1970, or even 1950), the message remains consistent: U.S. stocks are currently nearly as overvalued as they were at the height of the bull market.
How Valuation Models Stack Up
The recent bear market has been quite disheartening. Typically, bear markets are expected to decrease valuations enough to establish a more solid foundation for the next bull market. This would give the bull market a greater potential for upside than the previous one. However, this most recent bear market has been different. We haven't even recovered to the level where the bull market stood at its peak in early 2022, yet the current valuation of the S&P 500 is nearly as stretched.
The Predictive Ability of Valuation Models
It may provide some solace to the bulls that these valuation indicators offer little insight into the market's short-term direction. The predictive ability of valuation exists on a much longer horizon - typically five to ten years. Therefore, it is entirely possible for stocks to continue rising in the coming months despite market overvaluation. But if they do, the S&P 500 will be resting on an even flimsier foundation than it already is.
While it is concerning that the current valuation of the S&P 500 remains high despite the recent bear market, it is important to remember that valuation indicators are not reliable in predicting short-term market trends. Ultimately, the true impact of overvaluation will be seen over a longer time frame.
Also read: Stocks are on a seemingly unstoppable hot streak, but this bond-market 'tipping point' could see it end in a hurry
Plus: How much do you believe in this market? Your gut feeling matters more than the stocks and bonds you like.
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