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Do New Highs Mean Stocks are Expensive

March 2013

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Stock prices, as measured by the S&P 500 Index, are approaching all-time highs last seen in October 2007. It has taken the market almost four and one-half years to fully recover from the last downturn. As prices continue to rise, investors may wonder if stocks are now expensive and should be avoided. We don’t think so.

Although prices are just reaching new highs, the expected earnings for the S&P 500 Index reached an all-time high in the middle of 2011, almost two years earlier. The top-half of the chart below presents weekly prices (blue line) and forward 12-months earnings (green line) for the last 20 years. The bottom-half of the chart shows the ratio of those prices to those earnings (blue line) over the same period.

As you can see, the current level of the price/forward 12-months earnings ratio is 13.9. This is materially below the 20-year median for the ratio of 16.2.

We think today’s higher prices are supported by solid underlying earnings. Around the world, central bankers are pursuing policies designed to stimulate global growth. In the United States, our Federal Reserve is on its third round of quantitative easing. Likewise, European and Japanese central bankers are pushing similar easing policies. All of these policies support the opportunity for earnings to continue to grow for the next year or two.

We believe further earnings growth will not only help push stock prices higher but will also support greater investor confidence which will support higher valuations. We believe the lack of investors’ confidence is a big reason stocks trade below the longer-term median valuation.

This lack of investor confidence is also evident in the very high premium they are demanding from stock investments compared to fixed income investments.

Presented to the right is the Equity Risk Premium for the S&P 500. This Premium is calculated by comparing the earnings required by stock investors compared to the interest rates available to fixed income investors. Prior to 2007, stock investors generally required between 3% and 5% additional premium to assume the inherent uncertainty of stocks versus bonds. Since the end of the 2008-2009 recession, the premium has mainly been between 7% and 10%.

In other words, today investors are demanding twice the premium to own stocks, on average, compared to prior to the recession. This seems too high. Concerns about the European debt problems, our own fiscal cliff concerns, and slowing growth in China have combined to help push interest rates lower and equity risk premiums higher lately.

We believe the continuation of steady economic and earnings growth will allow confidence to improve which should push stock valuations (price/forward 12-months earnings) higher and equity risk premiums lower.

If the S&P 500 were to trade at its 20-year median of 16.2 times forward 12-month earnings it would be priced at 1,744 (16.2 X $109/share). Using the consensus estimate of $115/share for the end of 2014 and assuming a 16.2 valuation, the S&P 500 would be priced at 1,863 (16.2 X $115/share) at the end of 2013.

Do new highs mean stocks are expensive? We don’t think so.

We remain focused on understanding the current trends in fundamentals because it gives us the best probability for success. If you’re an active social media user, please consider sharing this topic with your acquaintances.