Valuation metrics like the price-to-earnings (P/E) ratio help us understand whether a security is cheap or expensive relative to history. And there’s some evidence that valuations can tell you something about long-term returns.
However, as reminds us: Valuations offer almost no signal as to what prices will do in the coming year.
“[W]e think the stretched valuation environment is a product of enthusiasm around equities,” Schwab’s Liz Ann Sonders and Kevin Gordon . “Yet, it’s hard to argue that high multiples in and of themselves represent a risk to the market’s near-term performance. Multiples can continue to move higher (as was the case in the late-1990s) and there isn’t a strong historical relationship between valuation and forward performance.”
The forward P/E on the S&P 500 is a little above 22x. Sure, that’s high. And it’s a metric that’s preceded negative annual returns.
But it’s a level that’s also preceded very positive annual returns numerous times.
The big takeaway is that there is between forward P/Es and one-year returns. In other words, the P/E ratio is a very poor market-timing tool.
“[T]he correlation between the S&P 500’s forward P/E and subsequent one-year performance — going back to the 1950s — is -0.11, which means there is virtually no relationship,” Sonders and Gordon observed. “Perhaps less important is the correlation and yellow line; more important is the range of outcomes, such as two opposite instances in which the forward P/E was 25, but in one case was followed by a ~30% decline the following year and in another case a ~45% increase in the following year.”
Now there’s all sorts of ways to slice and dice the data as you try to find any sort of signal.
As we discussed in the , history suggests P/E ratios could if the economy keeps growing. During periods where earnings growth is above average and monetary policy is accommodative, history says P/E ratios .
There’s also the fact that S&P 500 companies are “ than they were historically, which justifies higher valuations.
TKer subscribers already know that it’s not uncommon for P/E ratios to fall even as prices are moving higher. See , , and .
Ritholtz Wealth Management’s Matt Cerminaro made this less-than-intuitive observation in a recent .
Even with the S&P 500 trading above 6,000 right now, the P/E ratio today is lower than it was in September 2020 when the index was at 3,500.
“How?” said Ritholtz Wealth’s Matt Cerminaro. “Because earnings are surging.”
The P isn’t the only variable moving in P/Es.
As this of S&P 500 quarterly earnings per share (EPS) from Deutsche Bank’s Binky Chadha shows, the E has historically tended to go up.
This means that , the denominator E has put downward pressure on the P/E.
Analysts expect in 2025 and 2026. That means even if prices go sideways, valuations could fall . It also means there are scenarios where valuations fall and prices keep rising.
Nick Colas, co-founder of DataTrek Research, had a great anecdote in his Aug. 19, 2022 note:
Valuation alone is not enough. At the old SAC, rookie analysts often made the mistake of pitching Steve [Cohen] short ideas based on valuation metrics like P/E ratios or EBITDA multiples. His reply was always the same: “Everyone owns a calculator. Math is not an edge.”
In his Nov. 22 note, Colas referenced that anecdote as he discussed the data behind .
“Valuations and the manifold uncertainties around the next 12 months make it easy to be bearish here but, in keeping with our mantra that ‘math is not an edge’, we remain positive and believe the S&P 500 can rally more than its long-term average over the coming year,” he said.
All that said, it’s totally possible we experience a year of poor returns where P/E ratios contract. If that were to happen, few would be shocked as it would arguably be “rational” behavior.
But markets have a tendency to not behave that way.
There are all sorts of good reasons why you might expect the stock market to go sideways or fall in the next year. But a 22x forward P/E ratio alone isn’t a reliable one.
Last Sunday evening, Oppenheimer’s John Stoltzfus his 2025 S&P 500 year-end price target: 7,100. This is on $275 earnings per share (EPS) for the year.
“The quality of economic, business, consumer and job growth data from the start of the Fed’s rate hike cycle in March of 2022 through the initial cuts to its benchmark interest rate in September and November (and likely again this month of December) suggests further underlying support for the economy to sustain the current bull market,” he wrote.
On Monday, Societe Generale’s Manish Kabra a more modest outlook with his 6,750 target on $267 EPS.
“The three big positives under the new US government: 1) lower taxes to accelerate ‘reshoring’; 2) lower regulation with a focus on ‘supply side’ reforms; and 3) lower oil price to keep inflation in check,” Kabra wrote. “On the flip side, risks are tit-for-tat tariffs, causing inflation to rise and fiscal indiscipline, driving the cost of borrowing even higher. Trump 1.0 showed tax-cuts were announced before the tariffs to insulate the markets. Post the first 100-days, the Fed, inflation, tariffs and fiscal anxiety will feed into the market.”
President-elect Donald Trump, with Lynn Martin, President NYSE, center, Melania Trump, right and trader Peter Giacchi, left, walks the floor of the New York Stock Exchange, Thursday, Dec. 12, 2024, in New York. (AP Photo/Alex Brandon) ·ASSOCIATED PRESS
Fundstrat’s Tom Lee, meanwhile, expects the S&P to rally to 7,000 in the first half of the year before settling at 6,600 at year end on $260 EPS. From his Dec. 10 note: “THESIS: TWO ‘PUTS’ MAKE IT RIGHT: – Fed ‘put’ as inflation eases and Fed focuses on supporting employment – Trump ‘put’ as White House implements policies to boost confidence & EPS – Re-allocation of investor capital from cash/bonds to equities.”
In a Dec. 6 note to clients, Citi’s Scott Chronert initiated his 2025 year-end target at 6,500.
“We believe post-election euphoria reflects confidence in longer-term growth drivers, but our structurally positive view on S&P 500 fundamentals does have a myriad of issues that need to be navigated,“ he said (via ). “Ongoing soft landing and artificial intelligence tailwinds now interact with Trump policy promises, and risks. … Continued broadening beyond mega mega cap growth impacts is critical but an extended valuation starting point will be an ongoing hurdle.”
So far, we’ve been discussing strategists’ (top-down) forecasts. It so happens that the industry analysts (bottom-up) have price targets that are roughly in line with the median strategist’s target.
“Industry analysts in aggregate predict the S&P 500 will have a closing price of 6,678.18 in 12 months,” FactSet’s John Butters . “This bottom-up target price for the index is calculated by aggregating the median target price estimates (based on the company-level target prices submitted by industry analysts) for all the companies in the index. On December 11, the bottom-up target price for the S&P 500 was 6,678.18, which was 9.8% above the closing price of 6,084.19.”
There were a few notable data points and macroeconomic developments from last week to consider:
Stock buybacks are high, but the level is close to average. From S&P Dow Jones Indices senior index analyst Howard Silverblatt: “S&P 500 Q3 2024 buybacks were $226.6 billion, down 4.0% from Q2 2024’s $235.9 billion and up 22.1% from Q3 2023’s $185.6 billion. The 12-month September 2024 expenditure of $918.4 billion was up 16.7% from the prior 12-month expenditure of $787.3 billion.”
“Buybacks as a percentage of market value declined to 0.515% from 0.537% in Q1 2024; the historical average (from Q1 1998) is 0.641%.”
Inflation remains cool. The (CPI) in November was up 2.7% from a year ago, up from the 2.6% rate in October. This remains near February 2021 lows. Adjusted for food and energy prices, core CPI was up 3.3%, unchanged from the prior month’s level.
On a month-over-month basis, CPI and core CPI were each up 0.3%.
If you annualize the six-month trend in the monthly figures — a reflection of the short-term trend in prices — core CPI climbed 2.9%.
Inflation expectations remain cool. From the New York Fed’s : “Median inflation expectations increased by 0.1 percentage point at all three horizons in November. One-year-ahead inflation expectations increased to 3.0%, three-year-ahead inflation expectations increased to 2.6%, and five-year-ahead inflation expectations increased to 2.9%.”
Households feel better about their finances. From the New York Fed’s : “The share of households expecting a better financial situation in one year from now rising rose to its highest levels since February 2020, while the share expecting a worse financial situation fell to its lowest level since May 2021.”
Household wealth is up. From : “Household net worth increased nearly $4.8 trillion, or 2.9% from the prior quarter, to $168.8 trillion, a Federal Reserve report showed Thursday. The value of Americans’ equity holdings rose $3.8 trillion. The value of real estate eased by almost $200 billion after sizable advances in the first half of the year.”
Mortgage rates tick lower. According to , the average 30-year fixed-rate mortgage fell to 6.6%, down from 6.69% last week. From Freddie Mac: “The 30-year fixed-rate mortgage decreased for the third consecutive week. The combination of mortgage rate declines, firm consumer income growth and a bullish stock market have increased homebuyer demand in recent weeks. While the outlook for the housing market is improving, the improvement is limited given that homebuyers continue to face stiff affordability headwinds.”
There are in the U.S., of which 86.6 million are and (or ) of which are . Of those carrying mortgage debt, almost all have , and most of those mortgages before rates surged from 2021 lows. All of this is to say: Most homeowners are not particularly sensitive to movements in home prices or mortgage rates.
Gas prices tick lower. From : “Going nowhere fast is an apt description of the national average for a gallon of gas, which shed less than a penny since last week to reach $3.02. It has been close to the $3 level for five weeks yet faces stubborn resistance.”
Card spending data is holding up. From JPMorgan: “As of 02 Dec 2024, our Chase Consumer Card spending data (unadjusted) was 1.4% above the same day last year. Based on the Chase Consumer Card data through 02 Dec 2024, our estimate of the US Census November control measure of retail sales m/m is 0.47%.”
From BofA: “Total BAC card spending per HH was up 0.6% y/y in Nov. We forecast 0.5% increases in ex-autos & core control retail sales. In the weeks of Thanksgiving and Cyber Monday, spending on holiday items was 6.1% higher than in 2023. In fact, holiday spending is running ahead of cumulative 2023 levels despite a delayed Thanksgiving.”
Unemployment claims rise. rose to 242,000 during the week ending December 7, up from 225,000 the week prior. This metric continues to be at levels historically associated with economic growth.
Wage growth is cooling. According to the , the median hourly pay in November was up 4.3% from the prior year, down from the 4.6% rate in October.
Small business optimism spikes. The surged in November. From the report’s commentary: “[C]learly a response to the presidential election. The election results signal a major shift in economic policy, particularly for tax and regulation policies, that favor economic growth.”
Notably, the more sentiment-oriented “soft” components of the index have converged with the more tangible “hard” components.
Labor productivity inches up. From the : “Nonfarm business sector labor productivity increased 2.2% in the third quarter of 2024, the U.S. Bureau of Labor Statistics reported today, reflecting no revision from the preliminary estimate. Output and hours worked were also unrevised, increasing 3.5% and 1.2% respectively. (All quarterly percent changes in this release are seasonally adjusted annualized rates.) From the same quarter a year ago, nonfarm business sector labor productivity increased 2.0% in the third quarter of 2024, as previously reported.”
Offices remain relatively empty. From : “Peak day office occupancy was 61.3% on Tuesday 12/3, up 17.5 points from the previous Tuesday. Occupancy on Wednesday 12/4 also rebounded to 60.1%. The average low day was on Monday 12/2 at 47.3%.”
The entrepreneurial spirit is alive. Small business applications are up and remain well above prepandemic levels. From the : “November 2024 Business Applications were 448,758, up 5.5% (seasonally adjusted) from October. Of those, 157,678 were High-Propensity Business Applications.”
Near-term GDP growth estimates remain positive. The sees real GDP growth climbing at a 3.3% rate in Q4.
The long-term for the stock market remains favorable, bolstered by . And earnings are the .
Demand for goods and services is , and the economy continues to grow. At the same time, economic growth has from much hotter levels earlier in the cycle. The economy is these days as .
To be clear: The economy remains very healthy, supported by . Job creation . And the Federal Reserve — having — has .
We are in an odd period given that the hard economic data has . Consumer and business sentiment has been relatively poor, even as tangible consumer and business activity continue to grow and trend at record levels. From an investor’s perspective, is that the hard economic data continues to hold up.
Analysts expect the U.S. stock market could , thanks largely due to . Since the pandemic, companies have adjusted their cost structures aggressively. This has come with and , including hardware powered by AI. These moves are resulting in positive operating leverage, which means a modest amount of sales growth — in the cooling economy — is .
Of course, this does not mean we should get complacent. There will — such as , , , , etc. There are also the dreaded . Any of these risks can flare up and spark short-term volatility in the markets.
There’s also the harsh reality that and are developments that all long-term investors to experience as they build wealth in the markets. .
For now, there’s no reason to believe there’ll be a challenge that the economy and the markets won’t be able to overcome over time. , and it’s a streak long-term investors can expect to continue.
