Other Valuation Considerations
We believe the aforementioned valuation metrics paint a relatively full picture, but there are several other considerations.
• Watch cash flows. Getting a bit technical, cash flows matter more than earnings, which are an accounting measure that can be distorted. Free cash flow yield (cash flow left after capital investment versus price) is about 4.1% for the S&P 500 right now. That reading is higher, i.e., cheaper, than the average in the 1990s and not too much pricier than the 30-year average of 4.9%. But again, rates were higher during most of that 30-year period, which we believe supports lower free cash flow yields we are seeing in the current lower-rate environment. And cash flows remain depressed by the economic cycle, which inflates current valuations. We expect cash flow growth over the next 12 months will make stocks look even more attractive on this valuation metric.
• Efficiency boom. The tech boom in recent decades has enabled companies to do more with less. Fewer employees and less capital equipment are needed to run many businesses today—particularly technology and internet businesses. That enhances return potential for tech-savvy operators, which shows up in higher returns on assets and higher returns on invested capital. For example, Amazon’s return on assets in 2020 was 7.8%, compared with 5.5% for Walmart. And Amazon’s return on invested capital last year was 14.1%, compared with Walmart’s 9.7%.
• Tax rates matter. Dividend and capital gains tax rates combined averaged 42% during the 2010s, compared to 106% in the 1970s, 70% in the 1980s, and 63% in the 1990s. Higher tax rates impact investors’ expectations for after-tax returns, which we believe helps justify above-average stock valuations over the past two decades and currently. At the same time, the possibility that these tax rates increase next year, as President Biden has proposed, could cause valuations to narrow.
• Valuations are not good short-term timing tools. Remember that in the short term, valuations are not good timing tools. Historically, there has been little relationship between price-to-earnings ratios and subsequent one-year returns. So, while we want to be mindful of valuations, they are only part of the picture. They have historically begun to become useful as timing tools when time horizons are extended to at least three years.
Conclusion
Stock valuations are elevated right now, and a lot of good news is priced in. However, we believe valuations are quite reasonable when considering interest rates are low and we expect inflation to remain largely contained. Investors are appropriately optimistic in our view, given the backdrop of a dramatically improving economy, the rapid pace of vaccinations in the U.S. that is facilitating the reopening, massive levels of fiscal and monetary stimulus, and surging earnings.
We see further upside potential for stocks between now and the end of the year—although the pace of gains is likely to moderate relative to the 11% year-to-date advance for the S&P 500. We acknowledge our year-end fair value target range for the S&P 500 of 4,050–4,100 may prove to be conservative and are considering higher targets. We continue to recommend investors overweight equities and underweight fixed income relative to their targets, as appropriate.
Jeffrey Buchbinder, CFA, is an equity strategist at LPL Financial.