As we enter the tenth year of the bull market, stocks are no longer cheap. The market has risen significantly since the financial crisis, pushing valuation ratios above their long-run averages. Corporate earnings remain strong and continue to propel stock prices. If the economy continues to grow at a steady pace, the market could also continue to generate single-digit returns.
The stock market has generated spectacular returns since it bottomed on March 9, 2009. Few investors expected this type of market recovery at the time. After all, there have been many causes for concern over the past eight years including the U.S. debt ceiling, the Eurozone crisis, China’s economic imbalances and Brexit.
Through all this, U.S. economic growth has been steady, allowing corporate profits to grow and stocks to appreciate despite these macroeconomic and geopolitical concerns. While we are probably in the later stages of the cycle, there aren’t clear signs of an end just yet.
Short run chart
Long run chart
Valuation ratios are well above average for the broad market. The P/E ratio is now at its highest level since the dot-com bubble. This suggests that the market is no longer cheap, and by the same token, we should expect lower long-run returns.
Other valuation ratios are above their historical averages as well. For instance, the price-to-sales ratio (PS) is two standard deviations above average. This is because profit growth has outpaced sales growth as companies have cut costs and increased their profit margins.
Price divided by estimated next-twelve-month earnings per share
Valuation ratios for the S&P 500 index, since 2003
Corporate earnings have grown rapidly since the financial crisis, driven by two factors. First, companies cut costs in the wake of the recession which increased profit margins. Second, companies have used excess cash to repurchase their shares, which boosts earnings-per-share. These developments have been positive for investors.
Trailing 12 month EPS
The standard sign of a stock market bubble is “irrational exuberance.” Investors begin to bet on future increases in stock prices based on past momentum or the promise of new technologies.
Indicators of investor sentiment picked up after the presidential election but have moderated this year. Many investors are unsure how to feel about a stock market that continues to reach new highs this late in the economic cycle.
Bull-bear spread and neutral responses
Stock market volatility is extremely low by historical standards. While this isn’t unprecedented – volatility can be low for long stretches of time – it could mean the market isn’t properly pricing in risk given the current economic environment. So while the VIX is not a market-timing tool, it does suggest that the market could be fragile to unforeseen shocks.