The Big Picture

Briefing.com Summary:

*High valuations aren't necessarily sell signals, but they raise the stakes for bad news.

*There is a valuation gauge that suggests investors are "playing with fire."

*Fundamentals are the tripwire: one shock-- rates, earnings, geopolitics-- and the bull run could stumble.

If you can imagine running with the bulls in Pamplona, then you can imagine the state of the stock market right now. There is excitement, there is frivolity, there is nervous energy, and there is a big risk of getting run over if something trips you while you are in front of the bulls.

Right now, there are many participants staying ahead of this bull market by favoring the mega-cap stocks, AI growth plays, and heavily shorted issues. It isn't all fundamental business. In some cases, it really is just fun and games.

A herd mentality has taken over. Buy any dip... stay with the mega-cap names... invest in themes... buy memes... or, as CNBC's Jim Cramer likes to exclaim at times, "buy, buy, buy!"

You know what? It has worked. Frankly, the herd has been running as dominantly as Usain Bolt. It doesn't have any gold medals to show for it, but it has major indices at record highs and huge gains as victory-laden substitutes.

This market is undoubtedly running with the bulls, and it has the premium valuation to show for it. That isn't a problem until, well, something fundamental trips up the market.

A View of a Premium Valuation

Valuation itself is not a good market timing indicator.

In other words, just because the market trades with a premium valuation doesn't mean you have to sell everything and go to cash. It doesn't mean you should flip from long positions to short positions, and it doesn't mean a crash is imminent.

A premium valuation, however, does present a warning sign that downside risk can be material if other fundamental factors or exogenous forces alter the market's stride in an appreciable manner.

That could be a spike in interest rates due to something like a debt crisis or untamed inflation; it could be disappointing earnings growth; it could be a credit episode; it could be a geopolitical event like China invading Taiwan; it could be a fiscal shock like a large tax hike; it could be a global pandemic; or it could be the infamous "Black Swan" (i.e., the thing no one saw coming).

One can imagine all sorts of risk factors. The point is that a market trading with a premium valuation needs good things that justify the premium valuation to keep happening. If they don't, the market will, at best, lose its energy, or, at worst, devolve into a bear market.

So, what is the objective measure of a "premium valuation"? Let's go to the charts to illustrate that standing.

• S&P 500 P/E Ratio (price of the S&P 500 divided by forward twelve-month earnings estimate or trailing twelve-month earnings)
  • The FTM P/E ratio of 22.2 is a 33% premium to the 25-year average.
  • The TTM P/E ratio of 24.2 is a 32% premium to the 25-year average.

• Robert J. Shiller, Cyclically Adjusted P/E 10 Ratio (based on average inflation-adjusted earnings from previous 10 years) 
  • It stands at 37.8 today versus 38.6 in December 2021 and its peak of 44.2 in December 1999.

• The Buffet Indicator (how Warren Buffett views things): "If the percentage relationship falls to the 70% or 80% area, buying stocks is likely to work very well for you. If the ratio approaches 200%—as it did in 1999 and a part of 2000—you are playing with fire."

Briefing.com Analyst Insight

The high P/E ratio for the S&P 500 is grounded in the outperformance of its mega-cap constituents that have earned their keep in most instances. Arguably, that makes the complexion of today's high P/E ratio different than the high P/E ratios of the past when companies didn't have the earnings power that these mega-cap stocks have demonstrated.

The caveat is that the exact same point could have been made in late 2021 and earlier this year (pre-Liberation Day), and that didn't stop the S&P 500 from suffering a material decline. Why? In both instances, there was a perception that their earnings prospects wouldn't live up to high expectations. That was because the Fed was aggressively raising rates in 2022 to tame inflation and because recession fears were elevated earlier this year when the president first announced the reciprocal tariff rates.

Those reactions proved two things: (1) you can't use valuation in isolation as a basis to time the market, and (2) a change in the fundamental outlook, coupled with the high valuation, became the catalyst for the aggressive selling interest during those periods.

Valuation matters. It simply matters less as a selling catalyst in bull markets governed by a positive fundamental outlook. High valuations can be the basis for a consolidation period at any point during a bull market run, yet they become the basis for a correction, or worse, when the fundamental outlook gets tripped up. That is true for individual stocks as well as the broader market.

Given that, relish the excitement, the frivolity, and the energy of this run, but don't completely ignore the risk of running with the bulls. If you do, you may end up getting the horns.

--Patrick J. O'Hare, Briefing.com