It’s a truism that what goes up, must come down—but when, and by how much? That matters, especially if you’re talking about the US stock market.
With the S&P 500 approaching the 2000 mark and nearly three times its low point in early 2009, market pundits have started to say a correction is overdue. After all, as many note, the S&P 500 is selling at about 15.6 times consensus estimates of forward earnings—slightly higher than before the 2008 crash.
Clearly, US market valuations are well above their long-term average, as the left side of the Display, below, shows. Non-US stocks, both developed and emerging, are more attractively valued, based on their price-to-forward earnings. But we think that US companies today deserve some premium (compared to both their own history and to non-US companies) because their fundamentals are so strong: US companies are generating unusually high earnings, carrying much less debt, and returning more cash to shareholders via dividends and share buy-backs. Sometimes, you get what you pay for.
And relative to bonds with their ultra-low yields, all major stock indexes look decidedly attractive now, as the right side of the display shows. Comparing stocks to bonds is important: Where can investors go if they pull (or stay) out of stocks?
History suggests that market valuation tells us little about near-term market direction. The left side of the second display, below, portrays one-year returns for the S&P 500, arrayed by the price-to-forward earnings at the beginning of each period. When the market has previously been close to its current valuation, there has been a very wide range of returns in the subsequent year. That was also true when valuations were lower or higher. Basically, stocks can be very volatile in the short run, and the market could rise or fall significantly over the next year regardless of its valuation.
If you extend your time frame, however, the behavior of the market looks much more predictable. The right side of the display shows that with a five-year horizon, the range of market returns has been narrower. Furthermore, valuation has mattered over longer horizons: when the price-to-forward earnings has exceeded 20, the subsequent five-year S&P 500 return has, in most cases, been low or negative.
What does this mean for investors? We think that current stock market valuations are not a clear signal of what will happen in the next year or two. Stocks could drop, and if they did, we’d likely see it as a buying opportunity. Or the market could soar, possibly to a point where we would recommend paring back. But, most likely, we’ll see modest returns in the next few years.
Past performance does not guarantee future returns. The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AllianceBernstein portfolio management teams.
Seth J. Masters is Chief Investment Officer of Bernstein Global Wealth Management, a unit of AllianceBernstein L.P. (NYSE: AB)