Generally speaking, US-based stocks are known to be expensive. Recent booms in the 41 trillion market have shown benchmark stock prices sky-rocket to a point where only the dot-com era saw higher valuations. Though it is not the actual figures that concern investors, but rather the degree to which stock prices have peeled away from corporate earnings.
Price to earnings ratio is a way to measure the valuation of security by quantifying how many years of profit it would take to recoup the investment in their stock based on the company’s most recent earnings and profit returned dividends. However, this ratio is subject to high volatility due to peaks and troughs in the business cycle. Therefore many find it more useful to use the Cyclically Adjusted Price Earnings ratio or CAPE. Similar to the regular P/E ratio, it does not use the most recent earnings data but rather data over the past 10 years. For example, the Standard & Poor 500 (S&P 500) CAPE ratio climbed to over 33% at the start of this month. This figure is significant, as it is over 70% higher than its prior market average of 19%. The only comparable period to this was at the turn of the millennium, at the technology bubble height, when its ratio rose as high as 44.2 in December 1999. Other markets showing increases in this ratio include the Dow Jones Industrial Average (DOW) with a ratio of almost 30% and Nasdaq with almost 40%.
All such valuations have surged recently due to the COVID-19 pandemic, as central banks worldwide attempt to minimize the subsequent financial and economic fallout. March saw rates close to zero, and April saw government bonds being pledged to be bought out, pushing yields on long-term debts down to historic lows. Therefore, experts believe that equity over performance is namely due to low-interest rates and easing monetary policies.
This outperformance is most notably seen in technology stocks, which have surged the most this year, with an increase of 36%, which outpaced the broader market’s 14% gain. Tech companies such as Apple, Microsoft, Amazon, and Facebook now account for 22% of the S&P 500. This jump is significant as only at the end of last year did they comprise under 17%. Such above-average readings of the CAPE ratio are considered by experts, one reason why stocks have become untethered from corporate earnings. This proves that these increased valuations may prove troublesome in the long haul. Nevertheless, the S&P 500 has notched a total return of more than 1,700% in recent years.