Veriton Investment

Wall Street Warms to a New Normal of Sky-High Equity Valuations

(Bloomberg) -- Equity valuations have soared into the stratosphere of late, drawing the ire of market skeptics who warn that now’s not the time to buy.

Yet shunning stocks because they appear “expensive” is a strategy that hasn’t stood the test of time, undermining the utility of relying on classic valuation metrics as market-timing tools.

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And now a growing number of Wall Street analysts are advising that it may be time to forget what you thought you knew about price-to-earnings ratios, particularly with the average multiple steadily pushing higher over the course of decades.

Take, for example, a recent analysis by veteran Wall Street strategist Jim Paulsen that shows the average valuation range has leaped over the course of this century, suggesting that efforts to draw comparisons to the past are a flawed approach.

The trailing 30-year average S&P 500 Index price-to-earnings multiple was roughly 14 in the early-1990s and it’s now about 19.5, according to his analysis. Prior to the ascent, the ratio remained in a tight range between about 13.5 and 15.5 from 1900 to the mid-1990s.

“There’s something weird going on with valuations from what they used to be — that is, there’s an upward trend in the valuation range,” said Paulsen, who now writes a Substack newsletter called Paulsen Perspectives.

The appreciation in stock multiples over the past three decades is a potential offset to bearish arguments that today’s artificial intelligence frenzy is destined to end like the Internet boom and bust of the late 1990s.

The shift raises two questions, according to Paulsen: How do investors judge a chronically moving valuation target, and will it continue increasing at a similar pace into “unchartered territory?”

He cites several possible reasons for the uptrend in multiples, and why a more expensive stock market may simply be the new normal. For one, US recession frequency has declined from about 42% prior to World War II to only about 10% in the last 30 years. Meanwhile, the US has evolved from an industrial economy to a technology and services economy, and the market itself has become more heavily weighted to growth stocks that command higher valuations.

Stock-market liquidity also has improved the growth of electronic trading and greater participation from individuals and international investors. A permanent rise in what Paulsen calls profit productivity — or real profits per job — has created a permanent upward bias to valuations. And finally, innovation cycles have quickened over history.

Paulsen’s not the only market watcher warming to the notion that higher valuations may be justified in the modern stock market. The premise was echoed last week by strategists at Bank of America Corp. The attributes inherent in the current mix of S&P 500 members — including less financial leverage, lower earnings volatility, increased efficiency and more stable margins than in decades past — help to support swelling multiples.

“The index has changed significantly from the ‘80s, ‘90s and 2000s,” Savita Subramanian, BofA’s head of equity and quantitative strategy, wrote in a Sept. 24 note to clients. “Perhaps we should anchor to today’s multiples as the new normal rather than expecting mean reversion to a bygone era.”

One reason multiples were so low in the 1980s and 1970s was because sky-high interest rates pushed up the cost of capital in ways that threatened the ability of companies to conduct operations, according to Jonathan Golub, chief equity strategist at Seaport Research Partners. Although it’s not currently a risk he sees, if borrowing costs were to similarly jump meaningfully higher, multiples could turn back down to the averages seen decades ago.

“I don’t think we’re in a situation where there’s a persistent upward drift in multiples — I think we’ve had a re-anchoring of multiples to a higher level,” Golub said.