While valuations remain somewhat elevated, we think they look reasonable after considering still low interest rates and earnings growth potential. Many investors assessing valuations look at the PE and stop there. The S&P 500’s PE is now about 21, compared with the long-term average near 17. By that measure, stocks do look overvalued, but we don’t think that metric provides a complete picture. Interest rates should be considered, as they tell us how much companies’ future profits are worth in today’s dollars, and they allow us to compare high stock valuations to even higher bond valuations. Taking into account expensive bond valuations and low interest rates, we think stock valuations are still reasonable.
If inflation risk remains manageable through year-end, as we expect, and yields rise only gradually, we would expect earnings growth to continue to support stock market gains.
Bonds: Safety Features
Interest rates moved off their historically low levels in the first quarter of the year, but have declined in recent months. Higher inflation expectations, the strong economic recovery, and a record amount of Treasury issuance later this year are all reasons why we believe interest rates may start to climb again. Our target for the 10-year Treasury yield at the end of 2021 remains between 1.75% and 2.0%.
Such a move would leave core investment grade bonds with modest losses over the rest of the year. Nevertheless, bonds still can play an important role in a portfolio as a source of income and as a diversifier during equity market declines.
We are also closely watching the Fed, which may announce plans to reduce its bond purchases later in the year. Any withdrawal of Fed support will likely be small, but could send signals on the future path of rates.
Conclusion
"Midyear Outlook 2021: Picking Up Speed" was designed to help you navigate a year in which economic conditions may continue to improve dramatically. Understanding the road immediately ahead is essential for navigating its twists and turns, but it will be thoughtful planning and sound financial advice that will keep us on the journey.
Ryan Detrick, CMT, is chief market strategist at LPL Financial. Jeff Buchbinder, CFA, is an equity strategist at LPL Financial.