Here's Why Stock Valuations Are Still 'Quite Reasonable'

The SPDR S&P 500 ETF Trust SPY is now up roughly 90% from its March 2020 lows in just 13 months.

A number of traditional valuation metrics are now indicating stocks are extremely overvalued relative to historical norms, but LPL Financial analyst Jeffrey Buchbinder said Monday there’s an excellent case to be made that stock prices are actually right where they belong.

Key Factors: In a blog post, Buchbinder said the S&P 500 is currently trading at about 22 times consensus forward earnings, significantly above its long-term average of about 17. The S&P 500’s Shiller PE Ratio, a longer-term valuation metric that accounts for 10 years of earnings data, is currently sitting at 37.6, more than double its long-term average of 16.8.

However, Buchbinder said investors shouldn’t get spooked by these valuation metrics for several reasons.

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• First, interest rates are a critical part of the stock valuation equation. Stock valuations have historically correlated inversely with interest rates, and rates are currently near all-time lows.
• Another factor for investors to consider is inflation. Historically, higher levels of inflation have been correlated to lower stock valuations, which makes sense because inflation typically triggers rising interest rates. Buchbinder said he expects inflation will rise above 2% in the near future, but inflation doesn’t typically start to weigh on stock valuations significantly until it exceeds 4%.
• In addition, Buchbinder said cash flows matter more than earnings in valuing stocks because earnings are more easily distorted. The S&P 500’s free cash flow yield is currently about 4.1%, which is not too far below its long-term average of 4.9% and in a seemingly reasonable range given low interest rates and depressed cash flows due to the pandemic.
• Another factor that has an impact on stock valuations is taxes. Capital gains taxes averaged 42% in the 2010s compared to 106% in the 1970s, 70% in the 1980s and 63% in the 1990s. Taxes impact investors’ expectations for after-tax returns, which has an indirect impact on stock valuations.

What Does It All Mean? At the end of the day, Buchbinder said the current S&P 500 valuation suggests investors are simply being appropriately optimistic given the macroeconomic circumstances.

“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,” Buchbinder said

Benzinga’s Take: Whether you believe stocks are overvalued, undervalued or appropriately valued, Buchbinder also made another important point traders should understand. Valuations matter in the long-term, but valuation has historically been a terrible way for traders to predict the market’s next move in the short term. There has historically been very little correlation between the S&P 500’s price-to-earnings ratios and the index’s subsequent 12-month returns.