Have sharemarket valuations gone too high?

There’s lots of nervousness about sharemarket valuations at the moment.

That’s understandable, especially regarding the US market which has more than tripled in value since the end of 2018.

Including dividends, the S&P 500 index has returned 14.5 per cent so far this year, already well ahead of the long-term average of about 10 per cent.

In the seven years before this one, the market has posted four 25 per cent plus annual gains, and another two where it was up almost 20 per cent.

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The lone decline was an 18 per cent fall in 2022, which is now long forgotten given all of the fantastic years surrounding it.

Part of the reason for this great run is the resilience of the US economy in recent years.

Aside from the brief (but harsh) 2020 recession, which was engineered, America hasn’t suffered a recession since the GFC in 2008 and 2009.

It’s weathered the storm of rising inflation and interest rates, tariffs and now the oil shock remarkably well, which has been reflected in the sharemarket.

The S&P 500 has also been propelled by the emergence of AI into the mainstream.

Chat GPT burst onto the scene in late 2022, helping lift US shares out of the funk they were experiencing at the time.

Since then, a raft of new and existing businesses across the broader technology sector have produced some returns that are nothing short of astounding.

That doesn’t mean those stocks are all overvalued, nor does it suggest the market is due for a fall.

Earnings have more than kept pace with share prices, and for the most part the rally has been driven by fundamentals rather than speculation.

The S&P 500 has rallied 20 per cent in the past year but it’s cheaper than it was 12 months ago, because earnings have grown even more than that.

Aggregate earnings for the S&P 500 index rose 32 per cent in the June quarter, relative to the same period a year earlier.

That was the second consecutive quarter of annual earnings growth above 25 per cent and the seventh consecutive quarter of double-digit growth.

When share investors think about valuations, they’re not simply focused on the current share price compared to the old share price.

They also think carefully about what you get for each dollar you put in, in terms of the underlying earnings, profits and dividends.

Right now, the price/earnings (P/E) ratio for the S&P 500 is 20.6, above the ten-year average of 19.5 but not dramatically so.

It’s also lower than the 22.8 that prevailed a year ago, which makes the S&P 500 about ten per cent cheaper today (relative to its earnings, at least).

Then again, if we look back to 1990 the average P/E is about 17, which starts to make today’s level of 20 look a bit more overdone.

However, the obvious counter to that argument is to consider the types of businesses which make up the index nowadays.

The potential earning power of NVIDIA, Apple and Microsoft is impressive enough to command a higher P/E.

In 1995 the three biggest stocks were General Electric, AT&T and ExxonMobil, so it’s not apples for apples, is it?

Then again, some market strategists believe the bubble is in earnings, rather than share prices.

They argue that huge AI spending is creating unusually high revenues and margins for some businesses, flattering those P/E multiples.

As capacity catches up with demand, we won’t face the same shortages and pricing power could fade, impacting earnings even if the technology itself is transformative.

I don’t know which of those scenarios (if either) will eventuate, so I’d hedge my bets.

It’s not wise to sit fearfully on the sidelines during a period of solid economic growth and strong earnings momentum.

If I can’t hear recessionary alarm bells ringing, I’m inclined to stay invested and stick to my strategy.

You don’t want to be all in on the tech and AI trade either, mind you.

That’s why many astute investors are ensuring they’re also exposed to other parts of the market, and the world.

Some of the less exciting sectors are more modestly valued with less enthusiasm priced in, while some regions are less susceptible to a potential AI stumble than others.

Valuations are elevated but they’re certainly not alarming, especially when the exceptional earnings growth of recent quarters is considered.

That doesn’t mean markets aren’t facing risks though, and it might ultimately come down to the sustainability of those earnings.

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