Although U.S. stocks have fallen sharply from their record highs, Goldman Sachs warns that “S&P 500 valuation is stretched relative to history.” That may be an understatement. Goldman looked at 9 valuation metrics for the S&P 500 Index (SPX) and found that the current values for 7 of them are significantly above historic averages for the period since 1976, as detailed in the table below. The data is based on Goldman’s report, which is appropriately named “Where to Invest. 2019 US Equity Outlook: The Return of Risk.”
Significance For Investors
Despite a 1% drop in the value of the S&P 500 year-to-date, 7 of the 9 metrics that Goldman studied are now registering higher equity valuations than 75% to 98% of the measures made since 1976. In the case of two metrics – cash flow yield and the ratio of cash flow to stock price — the lower the figure the higher the valuation. Thus, cash flow yield had been greater than it is now 81% of the time since 1976.
The current bull market has nearly quadrupled U.S. stock prices, as measured by the S&P 500, since it got underway nearly 10 years ago, in March 2009. As investor optimism about future corporate earnings growth has expanded, so have stock valuations.
The developer of the CAPE ratio, Nobel Laureate and economist Robert Shiller of Yale University, has been warning that current market valuations are unsustainable for the long run, as discussed in another Investopedia report. He is particularly concerned about “the public’s lack of healthy skepticism about corporate earnings, together with an absence of popular narratives that tie the increase in earnings to transient factors,” as he has written in an essay republished by MarketWatch.
One of the biggest causes for worry may be the ratio of U.S. stock market capitalization to GDP, a metric favored by master investor Warren Buffett. While he apparently has not made recent public comments on the matter, this indicator has been flashing warning signs to other investors and market watchers, per an earlier Investopedia article. Meanwhile, Goldman’s report presents 3 big risks for U.S. stocks in 2019 that make high-valuation stocks more vulnerable.
|3 Big Risks Ahead|
|Risk 1: Tariffs||2019 S&P 500 EPS may be 7% lower|
|Risk 2: Wage Inflation||Labor costs equal to 13% of sales for typical S&P 500 firm|
|Risk 3: Rising Bond Yields||Rapid rises in bond yields tend to depress stocks|
Goldman finds that a monthly change of 20 basis points (bps) or more (either up or down) in the yield on the 10-Year U.S. Treasury Note has occurred in 44% of the months since 1962. When the yield rises by less than 20 basis points in a given month, the S&P 500 can “digest” it, as Goldman writes. On the other hand, the index typically falls when the yield jumps by more than 20 basis points.
In his essay cited above, Shiller writes that “the U.S. stock market [is] the most expensive in the world,” based on his CAPE ratio analysis. Given several other valuation metrics that also are well above the norms of recent history, and coupled with key risks such as those presented by Goldman, investors would do well to prepare for the possibility of yet more downdrafts in stock prices. If what Shiller calls “healthy skepticism about corporate earnings” starts to dominate investor psychology, the declines may be dramatic.