Investors Beware: The Asset Valuation Paradigm Changed
The value of stocks versus bonds changed in slow motion before the eyes of all investors. The relative value of stocks versus bonds is often judged by price-to-earnings ratios but p/e multiples aren’t relevant in today’s financial economic conditions.
To stick with a financial plan through volatile times – and high volatility is expected in the near-term – here’s what an educated financial consumer needs to know.
The black line is the price of the S&P 500. The red lines show the historical range of stocks -- the price-to-earnings ratio of the S&P 500 at 16- and 19-times the profits expected by Wall Street analysts for the next 12 months ahead.
For decades, the S&P 500 index traded at between 16 and 19 times the 12-month profits expected by Wall Street analysts. When the black line exceeded the valuation range – for example, in the tech stock bubble of 2000 -- the price of stocks in the S&P 500 traded well above 19 times expected earnings – it was a bad sign.
Currently, stocks are trading well above the expected earnings for 2021, as shown in the dashed red lines. The Standard & Poor’s 500 index is trading at about 22.3 times profits projected for 2021, way over the 19 times earnings. Trading higher than the historical price to earnings ratio is likely to cause volatility for stocks in the weeks ahead, but measuring stocks by their p/e ratio is not relevant in current financial economic conditions.
During the tech bubble of 2000, the 10-year Treasury bond yielded 6% versus just 1.6% currently. It’s one thing to choose to invest in a 6% bond and an entirely different thing to buy a bond yielding just 1.6%. Stocks are currently more attractive relative to bonds than in the past. The stock versus bond valuation paradigm has changed materially.
In addition to the change in the valuation paradigm of stocks versus bonds, stocks are further being boosted by the explosion in money supply (M2), which is shown here in the red line. M2 is liquid assets that are held in savings, checking, and money market accounts as well as in cash.
The explosion in money supply shown here reflects only about $4 billion of the Covid aid dispensed through the end of 2020. Another explosion is about to hit this weekend -- the $1.9 trillion American Rescue Plan Act of 2021.
The economy is set to boom because of this unprecedented explosion in money supply, fueled by nearly $6 trillion of U.S. Government aid to individuals and businesses since the pandemic hit a year ago. As vaccination inoculates the economy, Americans are about to spend the excess liquidity on activities and stuff, which fuels growth. Some of that won’t get spent. Some of it will seep into assets, like real estate and stocks.
The Standard & Poor’s 500 stock index closed Friday at an all time high of 3,943.34. The index gained +0.10% from Thursday and is up +2.6% from last week’s close. Stocks are up +55.20% from the March 23rd bear market low.
Stocks are just one asset in a broadly diversified portfolio. They are the key growth asset for most Americans who aim to build wealth to create a sustainable retirement income or to leave assets to family. That’s because stocks are liquid compared to private investments, and far less opaque.
For more information about the valuation paradigm shift, please contact our office.
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