Stock Market Valuations Reaching a "Prove It" Moment
As of today, the S&P500 is trading at 22.4x P/E.
The bears will tell you that these valuation levels are egregious given the 40 million unemployed and deteriorating economy. To rebut, the bulls will explain that quantitative easing and low interest rate are enabling valuations to go even higher. The bulls are clearly prevailing as the S&P500 just closed out its strongest 50-day rally in history, but they have reached a critical “prove it” moment.
We can gauge the risk-reward of investing in stocks by comparing it against risk-free money.
With the S&P500 at 22x P/E, it roughly implies a 4.5% return on capital (E/P). The 30Yr US Treasury, on the other hand, currently yields 1.6%. On one hand you have 1.6% guaranteed, on the other you have 4.5% with some risk (business, bankruptcy, fraud, etc.) That’s a spread of 2.9%.
Is the extra 2.9% return worth the added risk? I can’t say for sure, but the charts below show how investors have answered this same exact question multiple times in the past…
It’s clear, investors have been unwilling to receive anything less than 250-300 additional basis points of return on a P/E basis, and 550 additional basis points on an EV/EBITDA basis. Stocks have systematically sold off at these levels. With rates seemingly back on the rise, over the next few weeks we’ll get to see just how far out on the risk curve investors are actually willing to extend.
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