Markets are expensive
Despite these concerns, the market continues to show resilience, with the S&P 500 hovering near record highs. This apparent contradiction can be explained by several factors. First, while valuations are high, they are not entirely unreasonable given the current economic environment. Factors like strong corporate earnings growth, driven by technological advancements and a healthy economy, support a higher valuation.
Second, historical trends suggest that bull markets can persist even when valuations appear stretched. The S&P 500 has experienced extended periods of growth with high price-to-earnings ratios in the past, demonstrating that investors are willing to pay a premium for continued strong performance.
However, it’s crucial to acknowledge the risks associated with high valuations. Elevated bond yields, driven by potential inflationary pressures and government spending plans, could begin to weigh on stock prices. In fact, the all-important 10-year U.S. Treasury is now 4.4%. Its yield has risen by almost 400 bps since bottoming during the summer of 2020 and is up roughly 70 bps since the Fed announced its first rate just two months ago. The equity risk premium, which compares the expected return on stocks to that of bonds, has shrunk, suggesting that stocks may not offer as much reward for the additional risk they carry.
Nonetheless, while valuations are undoubtedly high, several factors support continued market growth. Corporate profit margins have been steadily expanding from approximately 9% in 2005 to the current average of 13%. Valuations are also supported by investor expectations that AI-related productivity gains and revenue opportunities will propel future margin expansion. Lots of cash and money market assets in investor accounts also support the current peak valuations. But just because the stock market averages trade at peak valuations doesn’t mean that all stocks are expensive, or trade at peak levels. There are winners and losers.
Tale of the retailers
The retail industry provides a good example of the diverging fortunes despite the valuations level of the broad market. This past week, we heard from several retailers as they reported quarterly results. Walmart and Target provided very different outlooks despite operating in the same economic climate. Walmart exceeded expectations, attracting higher-income shoppers and growing online sales, leading to an increased full-year forecast. Conversely, Target missed earnings projections, blaming reduced discretionary spending and supply chain issues for its sluggish performance.
Analysts suggest Target is losing market share to Walmart and Amazon due to an overreliance on discretionary items and potential internal operational challenges. Another view is that Walmart and Amazon just have too much scale combined with sophisticated technology which makes it increasingly difficult for many retailers to compete. Other retailers such as Costco, Home Depot, Lowes, TJ Maxx, etc. have carved out niches, but those retailers that haven’t are likely to suffer the same fate as the department stores.
Is the Oracle of Omaha predicting a market selloff?
One person that does seem to think markets are expensive is Warren Buffet. His Berkshire Hathaway has been steadily increasing its cash reserves, reaching a record $325.2 billion by the September quarter-end. This accumulation comes from significant stock sales, totaling $166 billion over the past two years, including shares of Apple and Bank of America. Notably, Berkshire has also ceased its stock buyback program, a move interpreted as a signal that Buffett views the market as overvalued. Instead, the company is investing heavily in low-risk, short-term U.S. Treasury bills, capitalizing on their high yields.
This cautious approach aligns with the current state of the “Buffett Indicator,” which compares total U.S. market capitalization to GDP. This metric suggests that the stock market is currently at its most expensive level ever relative to the size of the economy. While Buffett has sometimes distanced himself from the indicator, his actions speak volumes about his perception of market valuations. Berkshire’s shift toward cash has understandably made some investors nervous.
Don’t predict – prepare
Investors should carefully consider their own risk tolerance and investment goals when market valuations become as rich as they are today. While no one can predict with certainty and regularity when the market will sell off, the prudent investor is prepared to withstand market volatility before it occurs. I am reminded of Mr. Buffett’s comment about the importance of maintaining liquidity following the 2008 financial crisis when he said, “We did not predict the time of an economic paralysis, be we were always prepared for one.”
Hall of Fame quarterback Troy Aikman turns 58 today, United States Senator Dick Durbin is 80 today and actress Goldie Hawn turns 79.
Christopher Gildea, 610-260-2235