The S&P500, the most followed index of U.S. stock indexes, is now valued at its second highest level in history. In terms of the widely followed Shiller CAPE index, valuations have only been higher at the peak of the 2000 bubble. Yet, complacency reigns on the conviction that U.S. Fed monetization will fuel further rises. Moreover, investors have a remarkably ebullient view of the prospects of corporate America.
The Shiller CAPE ratio is shown in the chart below. At the current level, the market is valued at nearly 39 times inflation adjusted earnings of the past ten years. At this level of valuation, investors should expect low to negative future returns.
All the traditional valuation measures , except for one, point to an extraordinarily expensive stock market. The one exception — the multiple of 12 month forward earnings — is the pillar of optimism that supports the market.
The financial press has been full of headlines of late pointing to declining forward PE ratios as bullish for stocks. The chart below shows clearly this compelling argument. According to the reasoning, even though the S&P500 has risen sharply, it is actually the cheapest it has been in two years because earnings are rising dramatically.
The expected surge in U.S. corporate earnings assumes a sustained U.S. economic recovery from the Covid recession and, most importantly, a remarkable increase in profit margins. These have ramped up over the past two decades and are now expected to jump further, to record levels. We can see this in the chart below, courtesy of Ed Yardeni.
The expected expansion of earnings reflected in the forward PE is shown in a historical context below. This chart shows the post-war history of S&P earnings (1950-2021) in real (inflation adjusted) terms in logarithmic scale. We have added the consensus FPE to the series. What we can easily see is an unprecedented divergence from the trend.
Therefore, we have a bubble built on popular delusions. First, investors believe that the Fed will never let the market down; second, corporate profit margins which are already at record levels are going to increase much more; third, earnings will disconnect entirely from historical trends and from GDP output.
Good luck with that.