Vanguard’s reservations on market overvaluation
A significant portion of the investment sphere is of the opinion that the stock market is presently overstretched. The S&P 500 has skyrocketed 25% in the last year, considerably exceeding the 50-year annual average of 9%. The index has broken records in 38 sessions this year, with the latest on July 16, causing valuations to soar above historical levels.
As of August 16, the forward price-earnings (PE) ratio for the S&P 500 was recorded at 21, compared to the five-year average of 19.4 and the 10-year average of 17.9. This has sparked apprehensions among investors, including Vanguard, a leading investment management firm with .3 trillion in assets under management.
Joe Davis, Vanguard’s global chief economist, has openly addressed these risks. “For some time now, we have been warning investors that U.S. stocks — particularly growth stocks — are significantly priced,” Davis remarked in a recent statement. “In fact, the cyclically adjusted price-to-earnings ratio for the market is around 32% above our assessment of its fair value.”
The cyclically adjusted price-to-earnings (CAPE) ratio, created by Nobel Prize-winning economist Robert Shiller, employs average earnings from the past 10 years to neutralize the effects of any single year’s outcomes. As of August 27, the CAPE ratio was at 36.23, a level only outstripped during the dot-com frenzy of the late 1990s and the post-pandemic boom in 2021.
Even though Vanguard recognizes the overvaluation present in growth stocks and the overall market, Davis emphasizes that not all sectors are excessively valued. “Small-cap, value, and non-U.S. equities seem to be reasonably priced,” he noted.
The recent enthusiasm in the market, particularly regarding artificial intelligence (AI), has been a primary factor driving stock prices. Nevertheless, Davis cautions that this enthusiasm may be exaggerated. “It is highly unlikely that the swift economic and earnings growth resulting from AI would rectify the current excessive valuation of the U.S. stock market,” he stated.
To recalibrate the market to fair value within a three-year time frame, profits would need to increase by 40% annually—a pace that is twice as fast as during the 1920s when electricity transformed the economy. “This is double the annualized rate seen in the 1920s when electricity illuminated the country — along with economic productivity and corporate financial statements,” Davis remarked.
Goldman Sachs’ upbeat short-term projections
In contrast to Vanguard’s cautious viewpoint, Goldman Sachs holds a more upbeat perspective regarding the short-term forecast for stocks. Scott Rubner, managing director for global markets at Goldman, believes that corporate stock buybacks and algorithmic trading will persist in bolstering the market.
Rubner posits that sellers currently find themselves “out of options,” likely due to the substantial losses faced by stock bears over the past year. “Everyone is returning to the pool,” he commented, suggesting that algorithmic traders have likely overstated their downside risk with stocks.
Goldman Sachs further highlights that the Federal Reserve’s hint at a possible rate reduction next month could temporarily support stock prices. “The pain trade for equities leans upwards, and the threshold for adopting a bearish stance heading into a Labor Day barbecue is steep,” Rubner quipped, continuing his summer-themed analogy.
