The U.S. markets staged a stellar rebound in 2020, pulling back sharply from the low levels they hit in March to make it one of the quickest recoveries in stock market history. The S&P 500 gained 16.5% for the year that was marred by the U.S.-China trade war, the COVID-19 pandemic and the U.S. presidential election.
While some of these risks could still prevail in 2021, worries about an overvaluation of the S&P 500 have increased concerns whether the markets are in a bubble right now. In this article, we’ll analyse this hypothesis by looking at the current valuations, the growth potential in these markets and the factors which justify these expensive valuations.
Global P/E ratio vs. S&P 500 P/E Ratio:
Let’s start with looking at P/E ratios. These form the cornerstone of fundamental stock valuation analysis that help an investor gauge if the current value of the index is overvalued or undervalued when compared with the historical market P/E.
The trailing P/E ratio of the global equity market (3,000 public companies around the world based in 49 different countries) is 27.03 at the end of December 2020. The current trailing 10-year P/E for the S&P 500 is 34. 96. (Figure 1) — about 29% higher than the global average and 78% above the historical S&P 500 market average of 19.6. This puts the current P/E over 1 standard deviation, indicating that the market is certainly in the zone of “Overvalued”.
Figure 1: S&P 500 current P/E ratio vs. Historical average
Data as of January 2021|Source: Current Market Valuation
Policy support by the US Federal reserve and mass vaccine distribution likely to justify S&P 500 Forward PE
In terms of forward PE, the S&P 500 index is currently trading at 20.7x based on consensus earnings estimates for FY21. The overvaluation of the index is clear with standard deviation of more than three above its 10-year average of 13.9x (Figure 2). However, we believe U.S. equity markets will have structural support due to improving economic growth, supportive policies and possible mass distribution of the vaccine. Further, the U.S. Federal Reserve expects the economy to perform well over the next three years with the nominal GDP seen growing at 6% for 2021, 5.1% for 2022 and 4.4% for 2023. Against this backdrop, some of the major reasons why U.S. stock valuations are justified are:
- Low interest-rate scenario
- Increased consumer spending and higher retail sales growth
- Increasing weight of technology stocks in the S&P 500 index
- Double-digit earnings growth expected by top S&P 500 companies for 2021-2022
Figure 2: S&P 500 Index Forward PE valuation
Data as of December, 2020| Source: Bloomberg Finance
Note: * Forward PE is based on consensus FY21 EPS of USD 171.5
Biden’s $1.9 trillion stimulus push
Some of Biden’s stimulus aid is likely to flow into the market just like the last stimulus bill passed in 2020. Investors could rush to buy more cyclical stocks in the retail, energy and materials space in anticipation of strong earnings growth ahead. The spending comes at an interesting junction for investors as it could lead to more EPS upgrades, thereby justifying the expensive valuations.
Lower interest rates to support expansion in valuations:
The central bank’s decision to keep interest rates at near-zero for the next two-to-three years is likely to support an expansion in equity valuations as lower rates:
- Increase the discounted present value of future cash flows
- Encourage risk-taking behavior among investors by making leveraged positions cheaper
- Make dividends and returns on equities more attractive to investors when compared with fixed-income yields.
Swift rebound in consumer spending:
Aiding valuations is the U.S. consumer’s willingness to look past 2020 for better days. Retail sales are already higher than pre-pandemic levels, lifting sentiment and valuations. (Figure 3)
Figure 3: U.S. Retail sales growth Year-on-Year
Data as of December, 2020| Source: Moneycontrol.com
Increased weight of technology lifting the overall S&P 500 valuations:
Tech giants and technology-related companies are the most dominant U.S. companies in the S&P 500 index and are comparatively less sensitive to the cyclical aspects of the economy. Strong fundamentals, stable cash flows, upbeat earnings and dividend streams justify the high stock prices as the high price-to- earnings (P/E) multiples are outweighed by promising growth prospects.
Double-digit earnings growth expected by top S&P 500 companies for 2021-2022:
Several businesses and consumers are now conducting their day-to-day activities online, increasing e-commerce penetration and online media consumption. This trend is likely to continue, which is expected to drive double-digit earnings growth for technology giants like Apple (AAPL), Amazon (AMZN), and Microsoft (MSFT) (Figure 4). Earnings are likely to bounce back to reach $187 per share for FY2021 and $220 per share for 2022 for the S&P 500 EPS targets as per analysts’ estimates.
Figure 4: Top S&P 500 Earnings growth for 2021-2022
|S&P 500 Top 10 Holdings||Weight||2020 EPS %||2021 EPS %||2022 EPS %|
|Berkshire Hathaway Inc.||1.6%||-10.4%||15.4%||11.0%|
|Johnson & Johnson||1.2%||-7.9%||13.0%||9.0%|
|JPMorgan Chase & Co.||1.1%||-26.2%||22.2%||16.4%|
Data as of December, 2020| Source: Bloomberg Finance
Figure 5: S&P 500 Year-end 2021 Analyst Targets
|Analyst||Company||2021 S&P 500 Target|
|Dubravko Lakos Bujas||JPMorgan Chase||4,400|
|David Kostin||Goldman Sachs||4,300|
|Craig Johnson||Piper Sandler Companies||4,225|
|Binky Chadha||Deutsche Bank||3,950|
|Mike Wilson||Morgan Stanley||3,900|
Data as of December, 2020| Source: Companies’ Reports
Despite persisting fears about valuations, particularly among large-cap technology names, mammoth gains in some companies like Tesla (TSLA) (695% returns in 2020) only add to Wall Street’s anxieties about market bubbles. But, the good news is that many analysts see U.S. equities soaring new highs in 2021. Any market correction at current levels should be used as a buying opportunity. And, with stronger earnings projections for the next two years (2021-2022) and a rebound in economic growth, most analysts expect a 10%-15% potential upside on the S&P 500 from current levels in 2021.